Seems finally there is some work around solution to this issue. Though this solution is not at all feasible for lay man users who are just using an application which is calling a CHM, as this requires registry editing. What I feel Microsoft should come out with proper updates asap to fix this issue.

The solution is like this and it works in Win XP pcs.

Modify the ItssRestrictions registry entry to enable a specific security zone

Warning Enable only those security zones that you trust. Do not enable security zones about which you are not sure.

To modify the ItssRestrictions registry entry to enable a specific security zone, follow these steps:

1. Click Start, click Run, type regedit, and then click OK.
2. Locate and then click the following subkey:
HKEY_LOCAL_MACHINE\SOFTWARE\Microsoft\HTMLHelp\1.x\ItssRestrictions
Note If this registry subkey does not exist, create it by using Steps 2a and 2b in Method 1.
3. Right-click the ItssRestrictions subkey, point to New, and then click DWORD Value.
4. Type MaxAllowedZone, and then press ENTER.
5. Right-click the MaxAllowedZone value, and then click Modify.
6. In the Value data box, type a number from 0 and 4, and then click OK.
7. Quit Registry Editor.