Try using telnetlib.py from python3.1.  It fixes issues in telnet out of
band negotiations.  

http://svn.python.org/projects/python/branches/py3k/Lib/telnetlib.py

Here is what I think is happening:
HOST: b'User' + IAC + ECHO + DONT + b'name:\nPassword\n:'
read_until: times out on Username match, returns all HOST text so far.
You: *send username*
HOST: >
read_until: times out on Password match, returns '>'
You: *send password*
read_until: times out on '>' match, returns ''

This is the only way I could repeat the problem using a local Echo server.

Please let me know if using the telnetlib.py from 3.1 works for you.