They're sorting, just not the way you would expect.
System Icons are sorted first, then icons in the Documents and
Settings\All Users\Desktop folder, then icons in the Documents and
Settings\<yourusername>\Desktop folder.
On my PC, the system icons are first, then stuff like WebSite X5, Zoner Web
Gallery and CCleaner (in that order) appear before Excel, Word, Outlook,
etc...
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