This looks like the culprit:

changeset:   9184:f6eb03027411
user:        Bryan O'Sullivan <bos@serpentine.com>
date:        Wed Jul 22 15:26:27 2009 -0700
files:       mercurial/hgweb/hgwebdir_mod.py tests/test-hgwebdir
tests/test-hgwebdir.out
description:
Fix issue1679: path reconstruction in hgwebdir was mangling things badly

This particular area of code has a long history of back and forth
regressions. To make forward progress, we need a COMPLETE and DOCUMENTED set
of all the use cases we're trying to address, otherwise every fix for one
problem will continue to regress another.

In particular, this code probably needs to be pulled out in such a way that
we can make a unit test for it.