Solved it! well it's working at the moment!!
The server is running ISA server which then forwards requests to a central linux proxy. I turned off the ISA and redirected WSUS straight to the upstream proxy, bits started working in background mode and obeyed the group ploicy settings. Left WSUS using the upstream proxy and turned the ISA services back on and bits continues to work. Would ideally like to get WSUS to use the local ISA but this will do as a workaround for now