I have even moved the ntconfig.pol file down to the XP PC and changed the update method to update manually (and included the path to the file) to see if it was simply a problem with XP finding the file. When I look in the event log, I see and event 1054, which talks about the Group Policy processing being abandoned because it can't find the Domain Controller (doesn't mentioned the name of the Domain).
I can't tell if it is looking for an AD domain or NT domain and the 1054 error is not documented anywhere, including the Microsoft site (I have even clicked on the little Web link in Event Viewer which is supposed to document help on new Event IDs. Leave it to Microsoft to implement something to allow a process to be updated and then NOT UPDATE the information!
Event 1054 is now documented. See Q298656. Windows XP appears to be looking for a DNS server that's unavailable. Also, make sure that you've joined the computer running Windows XP to the NT domain and that you've placed Ntconfig.pol in the NETLOGON share.
This was first published in July 2002