I've seen this before. It usually has to do with how the content type, custom
site columns used in the content type, and custom document template were
created. If you create and set everything in the content type BEFORE adding it
to the document library it should work. If you add columns to the library in
addition to the ones in the content type I've seen it confuse the system this
way.

I took your advice regarding to not to add extra column to the library in
addition to the one in content type. I create and set everything in the content
type before adding to the document library; however, I still getting the same
error. It still pointing to different content type than the one I specifically
telling to use. Any other idea?

Did you also change the Doc Template used with the content type?

We're creating word documents and attaching them to the site content type.
We've tried it in 2 different ways.
1. we store the word doc in a Sharepoint library and attached the template to
it by using URL option. By doing this, office  2007 DIP pointing it to a
different content type.
2. store word doc in a SP library and attached the template to it by using
uploading option. This will open the right word document template. However, the
ability to maintain the template is not that great.