Running ESX 4.0 Update 1 build 208167 and vCenter build 208111.
Build a Windows 2008 R2 Enterprise VM from scratch. The OS and VMware Tools get installed without any trouble. Once you log into the VM, the mouse movements are very jumpy and not smooth. Jase McCarty pointed me to read KB Article: 1011709 , even though I am running Update 1, and tried removing the driver, but the problem still exists.
This is a known issue to VMware now and they are in the process of creating a new KB for the workaround.
Here is how to fix the video problem for Windows 2008 R2:
After you install VMware Tools, reboot, login and your screen will be jumpy.
The VMware Tools install should have created the folder: C:/Program Files/Common Files/VMware/Drivers/wddm_video