Part of what you're doing is adding some contrast, correct? If you look carefully the jaggies and blocks are there in the original image. It's just that the contrast is so low that they're not obvious. When you add contrast the difference between brightness of the blocks becomes more visible. Technically you're seeing what is more usually known as banding, where the original image didn't have enough brightness steps to represent the smooth tonal gradations.
Not sure what to suggest, other than i think the final image has too much contrast so adding less would be better. Maybe a little blur added to the veil area would help cover it up.
Are you applying the fX to the event, or to the track? Is any of this footage zoomed? Can you post the VEG file somewhere? I don't think that blocking is what I would expect to see on normal DV video. Can you post 2-3 frames of the DV video somewhere?