I'm glad that got things working for you!
Here's an update from the Department of Possibly More Information Than You Wanted...
I couldn't leave this mystery un-investigated... the WTF factor was waaaaay too high. So, I collated a bit of information from some internal resources to describe what is actually happening here:
Workstation has a feature called "Gaming mouse", which is designed to try to figure out when you are running a game inside the VM and to "optimize" the mouse for that situation. What does that mean? There are many (many) games where, if we were to track only the absolute mouse movement, we'd end up auto-ungrabbing from the VM at inopportune times. For instance, if you're using a pointing device to turn/move leftwards a lot in a first-person shooter, the effective position of the mouse pointer would soon depart the left edge of the VM's window, we'd ungrab while you're mid-game, and you'd say unpublishable things at your computer. So the Gaming mouse feature tries to figure out if you're playing a game in the VM, at which time we disable auto-ungrab. You can control this behavior in Workstation, Edit> Preferences, Input, Optimize mouse for games.
Unfortunately, there is no single magic thing that a VM does that tells Workstation that you're playing a game. We have to try to guess, based upon a number of factors of the VM's behavior. One of those factors is the visibility of the mouse pointer: Usually, if the hardware-supported mouse cursor is explicitly hidden by the guest OS, it means that the absolute position of the pointer is not relevant to the user, which is a h-u-g-e clue that we should enter gaming mode and disable auto-ungrab.
When you enable mouse pointer trails in Windows XP, it does a funny thing: Unless the video hardware has some bizarre support for pointer trails (which many don't, including Workstation's virtual SVGA), Windows turns off the SVGA hardware mouse pointer and starts drawing the pointer entirely in software. As far as Workstation is concerned, the guest mouse pointer is now hidden (we can't tell that those black-and-white pixels drawn by the guest OS are actually the mouse pointer), and bam, we go into gaming mode, disabling auto-ungrab.
Two workarounds are available: Disabling pointer trails in the guest or disabling "gaming mode" in Workstation's preferences.
Thanks for prompting me to investigate this... I learned a lot and can finally understand a bizarre facepalm-worthy quirk. Hope this information is useful!
Cheers,
--
Darius