Dont use SQL_Latin1_General_CP1_CI_AS / AI with a varchar variable datatype if you have unicode data. You will experience problems like the one you have due to an implicit conversion. Another example is documented here:

http://www.olcot.co.uk/sql-blogs/revised-difference-between-collation-sql_latin1_general_cp1_ci_as-and-latin1_general_ci_as

Note if you use unicode datatypes, you will get the correct answer, TRUE;

SELECT CASE WHEN N'ž'= N'Ž' THEN 'TRUE' ELSE 'FALSE' END

The newer windows collation Latin1_CP1_CI_AS / AI will give you the correct answer as it has better rules for comparing non-unicode to unicode data.

http://support.microsoft.com/kb/322112