It's been a while since I've encoded anything, but I believe that if the preview pane in VDub is displaying the <i> and </i> symbols, then those characters are being hardcoded onto your video. Make sure that you're using a filter specific to your subs file. (Or, convert your subs file to the needed format.)
A SubRip file (.srt) uses the <i>text</i> notation to denote italics, while SubStation Alpha (.ssa/.ass) files call upon preset font styles if italic formatting is needed. It sounds like you're trying to hardsub from a .ssa file...but the original .srt elements have been accidentally included...
Sorry for the long-winded post. Good luck with the project!