To be honest, I'm not 100% sure how this comes about. It seems to be when a program that is installed in Windows 7 which integrates features into the shell (Right-Click menu primarily), 7 doesn't seem to understand how to size it properly. The screenshot will explain this better than I have. Note that the red highlighted area should really not be there.
Examples of programs which integrate into the shell include WinRar, MagicISO - generally third-party apps. This was definitely not a problem in Windows Vista.
Do it the way Vista did it? I really don't know, but it's quite a severe problem. Just give the right click menu enough room for the icons where applicable.