This issue may also be DirectX related. Try this: uninstall completely your old Ati driver, clean registries, then install the latest driver; after that, refresh the DirectX install (I'd recommend that after each graphic driver update).
I have an ATI GPU (4890) and it performs flawlessly. However, I am aware it has 1Gb of VRam and other/older cards can "choke" on the new textures, so the whole matter may be not driver-related, but only hardware (so the above procedure won't help much). What might help would be adding some more RAM to your system, although I have no idea if M&B uses much RAM for graphic rendering or textures as Oblivion, for instance, does... Speaking of Oblivion, I used to play it also with an Nvidia 8800GTS and didn't have any problems, until I upgraded to the QTP3 texture pack, then I had to update my system. M&B is not a ressource hog as Oblivion is, although it may become, when you will play a battle with 100 units on Warband's updated graphics...
A couple of questions which may help to identify the reported graphic glitch: how many people were on the server at the time when the bug happened? And how many bodies do you have enabled (ie. try reducing the number of those and see if it helps - same for shadows)?