vato = Mexican Spanish. 1. man; 2. dude; 3. homeboy
According to the wikipedia article,
the word originated in Pachuco slang of the 1940s, and is derived from "the once-common friendly insult chivato, or goat. It had a slightly unacceptable air to it, which the Locos and Weesas of the Chuco world enjoyed. They were able to take the sting out of racism by calling themselves a bunch of names assimilated 'good Mexicans' didn't like."
It would appear that this is one of those situations where a minority community took a word commonly used to insult them and accepted it as a symbol of their distinctiveness, thus changing its meaning and even turning it to a symbol of defiance. Other examples may include the N-word or even the words cigán/cikán/cigány, normally a pejorative name, yet one used with pride by the Roma of Eastern Europe (before the post-1989 Roma revival) to emphasize and embrace their status as a minority and their distinctive culture.
The urbandictionary entry seems to agree on the original social context of the term, as it lists vato as a part of the gangsta slang and the equivalent of American English homeboy, which is also a word with strong gangsta culture connotation. On the other hand, there are more than a few examples which show the word in non-gangsta environment. One of them is item no. 4 in the above mentioned urbandictionary entry. Also, George Lopez uses the word vato in a plain, non-gangsta sense in one of his routines where he discusses the inability of Chicano men to express their emotions:
Vatos never wanna tell 'em ... that we love 'em.
("Team Leader", Track 13 - 'Love You-Sober')
Interestingly enough, Snoop Dogg's "Vato" may complete the circle: his popularity and his association with the gangsta culture could very well help supress the neutral meaning vato has acquired and reestablish it as a firm part of the cholo culture. Watch this space for further developments.