Since the "hosts" file is the first place the computer checks for hostname to IP address mapping, it just makes sense that malware would hack it to wreck havoc on a user's ability to navigate the Internet.
For example, some malicious code could change the hosts file so that one could end up going to a spoofed site that would allow malicious hackers to steal personal or financial data. This could happen and users would not know any better. Banks and PayPal web sites are often spoofed.
Another example is if the hosts file was used to keep one from reaching legitimate web sites. This is relatively easy. For instance, one could be blocked from going to ebay.com if an IP address to hostname mapping like "127.0.0.1 ebay.com" was added to the hosts file.
There are probably many other ways the hosts file can be maliciously used. However, here's the good news for Windows 7 users: changes can easily be done through various means on Windows XP, but in Windows 7 (and in Vista), one needs to get elevated administrative rights to make changes to the hosts file.