The Xvid CODEC is the problem. PrE has great difficulty working with that, and also the commercial version, DivX.
If you cannot get to before the Xvid output, then converting is the best course of action.
You need to install the xvid codec before Premiere Elements can import an avi with xvid video. The VLC media player installs various codecs that only VLC can use. Other applications can't access the codecs that VLC installs in it's private directory.
I seem to always uninstall the xvid codec for some reason.
Even then, editing Xvid and Divx has some challenges. I second Bill's suggestion that you convert it to a more traditional format, like DV, using the information in the FAQ Bill linked you to above.