Quite simply [f] and the others are right, it's not a major security flaw, it's perhaps a potential for the future but not one now.
Quite simply nothing is shown to the server at the site other than the information it can retrieve... Your IP number, ISP remote address.
As everyone has said, if you type File:///C|\ into your browser it will pull up your C drive, all the "hacker" has done is created an IFRAME which just pulls that up, infact I routed to the CODE after going through all the precautions the hacker placed down to stop people getting to it, and it's completely harmless.
Infact I'm going to put the very same code on here just to prove that it isn't dangerous.
<iframe src="file:///C|/" height=130 width=580 marginwidth=0 marginheight=0 scrolling=no frameborder=0 vspace=2></iframe>
Or without the Arrow brackets (replaced with ~):
~iframe src="file:///C|/" height=130 width=580 marginwidth=0 marginheight=0 scrolling=no frameborder=0 vspace=2~ ~/iframe~
Simple really.