Air carrier departure from ITH experienced momentary distraction from a Master Caution light and had a track deviation.

Narrative

The event was a loss of separation between our aircraft and another aircraft while we were on the initial climbout from ITH because of ATC error. We took off of Runway 14 and executed the departure procedure; which is climb heading 145 till 2400 ft. On the climbout during the pilot not flying checklist we noticed a master caution light illuminate and then quickly go out. At that point the checklist was interrupted to figure out if there was an issue with the aircraft and I went off frequency. After determining there was no issue the checklist was repeated and I went back on frequency. During the master caution light illumination and repetition of checklist the First Officer climbed to 2400 FT then hit the LNAV button so the autopilot and FMS would track direct to HNK VOR as per our flight plan. The advisory display panel illuminated CHECK NAV SOURCE and remained on heading mode instead of NAV. The First Officer was trying to make small corrections to track to HNK. I went back off frequency to call in times. The Controller asked us if we were on course and the First Officer replied we were on runway heading when she should have said we were on a heading. At some point the controller advised us of traffic and so her attention was diverted to looking for that traffic which we saw and maintained visual separation instead of correctly answering his question about our course. We were on course the entire flight and therefore should not have had a loss of separation as a result of our course. We also did not receive a TA or an RA during this flight. If there was a loss of separation it was a result of ATC not advising us in time of the traffic.