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OK, I see what is wrong. I had tried using the Cut Polygon tool but it never made a polygon - only a line which would not do the trick (which is why I started trying the Straight Segment tool). It never made a polygon because the last vertex was not snapping to the first one. I played with the snapping distance and it finally worked, but Arc does not give any indication if it is snapping or not (like it does when snapping to another feature layer, and as I'd expected).
So...all ends well.
I'm glad you figured out a fix. Another way to achieve this is to use the Clip tool as discussed here: http://help.arcgis.com/en/arcgisdesktop/10.0/help/index.html#//000800000004000000.htm. Know that when clipping you can only have one polygon selected at a time and taht it will clip all editable polygon layers that are visible.
You can find the Clip tool in the Editor toolbar via the Editor pull down menu. I use it fairly regularly so I have added teh tool as a button on my toolbar via the Customization menu
It sounds like you got the Cut Polygon tool to work for you. In my experince the Cut Polygon Tool usually only works if I begin my cut by placing a vertice outside of the polygon boundary, enter the ploygon for my cut then exit the polygon at another location.
Hope this helps!
Also, when trying to cut out a hole, you should turn on Snap To Sketch on the Snapping toolbar menu. That will make sure your cutting line makes a complete ring inside the polygon.
Can always use the Erase tool as well...