C2 refers to a level of trusted systems. I believe that you may actually be running a B level version of HP-UX which has military grade security features. I have some experience with 10.0 at C2 and it didn't behave like your system is. I'm not sure how much I can help you, but I do have a couple of ideas.
What does "The weird thing is that I changed the passwords for other users as well and have acheived the same results." mean? That these accounts are also screwed up? Can you login as any user?
There is a problem that you may have stumbled into: according to the
termio man page, the default ERASE character is # and the default KILL character is @. There are ways to change these defaults, but unless you did, neither character will be a reasonable choice for use in a password. In a shell where you have changed your ERASE and KILL characters, they will work with the su command. But they won't work with a login prompt. If this is your problem, you may be able to login as an ordinary user, change your ERASE and KILL characters, and then su to root. You might give this a try.