Found this on the VLC forums:
"Most MASTSHITA drives have an extra region protection that disables VLC (and *any* other player for that matter) playing region-mismatching CSS encrypted movies. The extra protection is that the drives REFUSES to read raw encrypted data sectors, that is, once the region mismatch has been detected, every read operation is aborted, i.e. I/O ERROR. It doesn't matter that VLC can do a crypto analysis and crack the CSS key, it can't READ THE MOVIE, so it can't play it."
Do you have a Matshita DVD drive?