And what would you do?

Dedicated to a certain member of my guild, who had better have gotten a clue before I see him again.

( cut for a somewhat-uncommon offensive term )

As far as I'm concerned, the proper thing to do when you hear or see someone use an offensive term is to privately let them know that the term they are using IS offensive. Nothing hurts the cause of polite discourse like attacking someone when they don't know the meaning of what they said.

Of course, this requires that they respond either "Oh dear, I had no idea, I certainly didn't intend that" or "You're right, (even though I meant to say it) that WAS rude of me, I'll knock it off."

I believe that if a term is generally understood by part of one's audience to have been historically used in a racist manner, it's not proper to use it even if one simply means the non-ethnically offensive part of the word, because that's still racist. There are plenty of non-racist terms you can use to call people lazy, dumb, or any number of other things if you like.

Further reading: Wikipedia's list; please note that the Germans have their own, much longer, page.