Alright. You want to use Virtualdub to encode the video.
Install ffdshow if you don't have it already.
Basically, in VDub, open the .avi in it. Set the codec it will use by hitting Ctrl+P. I recommend XviD in ffdshow. Choose ffdshow, hit configure. Change the encoder to XviD. Use one pass quality because anything more will be a more difficult and lengthy process. Change the quality number, remembering higher quality = more space. Hit ok twice.
Make sure audio (at top, click it) is on direct stream copy. Make sure video is on full processing mode.
Then go to file | save .avi.
This process may be a trial and error for you since you're new to it. After a few, you'll get really good and be glad you know how to do this.
Let me know if you need anything at all.