I did an install of XP (no service pack) into a VM about a month ago. Windows Update wasn't disabled under the unpatched OS, nor did I find it disabled under SP1, SP2 or SP3. Microsoft is no longer releasing new patches for anything except SP3, and the process was a PITA (we have an update for your update system, but before that update, you need to update this other update system,), but it was possible to bring the box from 0 to fully patched using just Windows Update.

With that said, the slipstream procedure Rory recommended is probably the best way to go in your situation. His instructions are the normal by hand route, and the alternative way is using a tool like nLite. It can take care of the slipstream and ISO steps only, or you can go deeper and create a slimmed down installer. Just be careful if you go the route of really customizing the install, as it is possible to leave something critical out, breaking something like Windows Update from functioning properly.