Okay I have solved the problem at my end. Perhaps this will work for you as
well.
I assigned a static IP address to the XPsp2 workstations outside of the
range checked by the proxy server. Ran Windows Updates - express setup
(which worked).
I removed the static IP addres on the workstation and returned it to control
of the DHCP server (which places back in a range controller by the proxy
server).
I then returned to Windows Updates - Custom Setup and installed some of the
non-critical updates. SUCCESS!!!
I will see if this solves the problem for critical updates as well when the
next one comes out... which shouldn't be too long
Hope this helps you too!