1) I am very impressed that you have engaged the thoughtful interest of kubecj ... definitely a plus
When we're loosing a battle, some soldiers ask for the general to come here 
I can feel for kubecj (and the gang here) actually: interesting problems do tend to attract sysadmins/developers like honey attracts bears

Maleas, from our tests it looks like the Internet Explorer settings are not taken in account when running under system account - according to my colleague it seems like there is no download of WPAD file. Oh my. 
Thanks for checking this mate! So the issue is confirmed.
Is Windows Update running on such a machine without any additional settings?
Yes, perfectly (and I do presume you are talking about the automatic windows update, the one showing up as the globe/yellow shield in the system tray when running).
Still, I believe you'll tackle the problem in no time, considering that this used to work just fine some months ago.
PS: I do have a newbie and a bit off-topic question, being a non-coder (at least for the last 10 years). Where does one change the way a Windows 2000/XP system connect to the Internet, when a SYSTEM (or other special Windows service) account is used? I mean, when in my account I set auto-proxy, or proxy script or manually specify proxy address and port, obviously that affects programs running under my own account, not the programs running under the SYSTEM (or other special service) account is used.
Extending the previous thought, avast gives the user the option to specify the way to connect to the internet. I presume though that whatever is entered there, is used regardless of the currently logged in user. For example if user abcd configures avast to use proxy xxxx:ppp, then user efgh will also see the same proxy selected in avast config. A systemwide setting, for that matter. What happens though when the "Use IE settings" is selected? I always presumed it meant "Use
my account's IE settings". Or does it mean (or it
should mean) "Use
System internet options settings"? Sorry if I managed to confuse you, this is not clear to me as well
