System Information
Windows 10, Nivida 9800 ti

Blender Version
Broken: 2.78
Worked: 2.49b

Short description of error
When using the proportonal editing tools, there is an octangler distortion to the falloff which produces sharp edges when using a smooth falloff for example. This error is persent with most operations but is really visible when editing a higher poly mesh.

Exact steps for others to reproduce the error
Open an empty scene.
Add a plane.
Enter edit mode.
Subdivide the plane 6 times.
Select a center vertex.
Enable Proportional editing "Connected" with falloff "Smooth".
Translate the vertex up by 1.
Notice the hard edges generated every 45 degrees.

Error:
https://dl.dropboxusercontent.com/u/38908748/Blender/Images/FalloffBug.png

2.49b vs Now:
https://dl.dropboxusercontent.com/u/38908748/Blender/Images/Compare.png