A webpage can read any file on the same server as it was loaded from (this is the cross-site policy of JavaScript). That means that the page file:///C:/mywebsite/index.html can read the file file://C:/somedir/somefile.xml. To read this file, either use ajax, load it in an iFrame or load it as a javascript or css file.
Several browsers support custom methods for loading local file (and other interesting things), IE has activeX and Firefox has XPCOM.