I should have posted earlier. I found a solution almost right after posting.
If you uncheck "automatically detect settings" under the lan settings and set your configuration script to "file://c:/proxy" then everything is fine. The key seems to be the autodetect. I'm not sure why, but if it is checked then it completely ignores the no-ads file. I have tested with both the IE6.29 and IE7 computers (both using XP home edition).
Hope this saves someone a few hours.
Steve
PS, you also need to close and restart IE if you make changes to the pac file.