This issue is consistently reproducible with very large scripts - I can get it to happen every time with a very large script. I'll attach a project that it happens with in a moment!

This issue is reproducible with the following project: massive-script.zip

Thanks for the repro! It appears that TextLabel.TextBounds is just straight up lying to us. Fun! I've reported this here: https://devforum.roblox.com/t/textbounds-is-completely-incorrect-for-text-with-many-lines/3252070

Your script has 13,262 lines. TextLabel.TextBounds (and TextService:GetTextBoundsAsync) both give a height of 17,488px.
That would mean each line is 1.3 pixels tall, which is why the syntax highlights are so cramped together.

Even when I compute the text bounds manually, it's broken because UDim2 Scale doesn't have the precision for the tiny values needed. If I use Offset, it won't work properly on High DPI screens... This sucks.

I believe there are more high-dpi users than massive script authors, so I'm inclined to say that we keep this as the lesser of two evils.

I actually just thought of a half-decent solution to this that'll also improve performance- I can make the diff view into a virtualized list and highlight each line individually, so that there's fewer labels and no textbounds issue

Sounds okay to me, but would it work for syntactical constructs that span multiple lines? For example multi-line comments:

--[[
    This is a multi-line doc comment.
  
    Say hi!
]]
local function sayHi()
end

or multi-line strings:

local s = [[
This 
is 
a 
multi-line 
string
]]

The highlights can be computed from the full string, but they'll be rendered line by line in a virtualized list. I didn't explain that well, so thanks for calling it out!