Can a player with HiPs ignore the need to make a distraction or use bluff to avoid the observer having a clue on where they hide?
For example, at the start of their turn they declare to hide with HipS, then they move and do their actions, leaving the observer deceived on where the hidden player acutally is.
Someone hiding normally needs cover to hide if they are observed, Player Handbook 76 says that this player, if being observed, would need a bluff check or a diversion to hide to avoid the observers to know where they went to hide.
Somone with HiPs (e.g. shadowdancer) can hide even if being observed.
Best Answer
Hide in plain sight typically makes a diversion unnecessary
The skill Hide, in part, says, "If people are observing you, even casually, you can’t hide" (Player's Handbook 76). The prestige class shadowdancer at level 1 grants the supernatural ability hide in plain sight that, in part, says that the creature "can use the Hide skill even while being observed" (Dungeon Master's Guide 195, and this is virtually identical to the special ability of the same name of the prestige class assassin a few pages earlier).
I've never encountered in real life or electronically another reading of this part of hide in plain sight, and I struggled to even find a way to read the ability differently (see below). I've always played—and have always assumed others played—that the ability means that there's no need for shadowdancers first to make Bluff skill checks (opposed by observers' Sense Motive skill checks) to create diversions then make Hide skill checks to conceal themselves. Shadowdancers can just hide as long as they meet the remaining necessary requirements for the Hide skill modified by the hide in plain sight ability.
Keep in mind that there's more to sneaking up on foes and stabbing them in the face than just not being seen. While effectively invisible, a hider in plain sight isn't inaudible, for instance, so successful Move Silently skill checks will be needed to keep the creature's location secret. (According to the Rules Compendium (92), a hidden creature is effectively invisible to those from whom the creature is hidden—see here.)
On the other hand…
So far as I'm aware, nothing in the game prevents a creature from attempting a Hide skill check while the creature's observed; the attempt just normally fails. With that in mind, I guess it's possible to read that part of the hide in plain sight ability as dysfunctional. That is, sure, a shadowdancer can use the Hide skill while being observed, but, y'know, so can anyone, right? Thus everyone—shadowdancer, assassin, commoner, dragon, demon, monkey, or sandwich and with or without the hide in plain sight ability—will always be about as successful as you'd expect when trying to hide and someone's watching. (To be clear, usually that's not very successful.)
Even though I don't find this train of thought particularly compelling—to put it mildly—, it's not up to me to prevent readers that want to read that part of hide in plain sight as dysfunctional from reading it that way. Those readers do have both my sympathy and respect, though. I don't know of an RPG that's written with that degree of linguistic precision, so those readers will find the hobby's spine a constant source of disappointment; still, I appreciate readers who keep their standards high.