The correct form is "I don't know where she lives." The reason is that when a question is embedded as part of a larger sentence (e.g. "I don't know _who he is_," "Do you know _where we should go_?") we don't use the normal question word order (as in "Does she live there?"). Instead we use the standard subject-verb word order that we would use in a statement. We don't add any auxiliary verb (such as "does") because we're not doing question word order and so we don't need it.
In short, you would say "She lives in Boston," not "She does lives in Boston," so the correct form is "I don't know where she lives."
I'm a native speaker and a linguist who just happened to stop in on this thread and I wanted to straighten things out.
