The American Bar Association's Model Rules of Professional Conduct say that "a lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent." In other words, a lawyer cannot knowingly permit her services to be implicated in a client's fraud. At the same time, however, the lawyer owes a duty of confidentiality to her client and the Model Rules do not permit disclosures necessary to correct a mere fraud (though many state bar codes do).
So, what to do? First, immediately notify a partner on the deal. If there is no past misconduct, good client counseling about avoiding liability and the stigma of fraud should induce corrective action. If, however, the client insists on making a misrepresentation in the deal, the lawyer and the firm must withdraw.
If the fraud is ongoing, withdrawal and refusal to work on the current deal may not be enough. In order to protect itself from complicity in the fraud, and notwithstanding its duty of confidentiality, the firm may have to expressly disaffirm any of its work reflecting the client's misrepresentations.
Young lawyers should always raise concerns that arise in the course of due diligence. They're ethically obliged to do so, partners are obliged to encourage frank discussion, and addressing such concerns is precisely what due diligence is for.
Summary: What if an associate performing due diligence on a transaction discovers evidence of fraud by her client? What if she discovers, say, the next Enron?