Operating System: WinXP Home, WinXP Pro
Level: Beginner, Intermediate

Here is the proper solution that disables the annoying dialog without disabling the automatic update services.

WinXP Home

Copy the blue text below into Notepad. Save it with a .reg extension. Open and confirm that you want to copy the data into your registry.

Windows Registry Editor Version 5.00

[HKEY_LOCAL_MACHINE\SOFTWARE\Policies\Microsoft\Windows\WindowsUpdate\AU]
"RebootRelaunchTimeoutEnabled"=dword:00000000
"NoAutoRebootWithLoggedOnUsers"=dword:00000001

WinXP Pro

Start -> Run -> gpedit.msc -> Local Computer Policy -> Computer Configuration -> Administrative Templates -> Windows Components -> Windows Update -> Re-prompt for restart with scheduled installations.

The problem is if you click 'disable' or 'not configured' the popup keeps coming up every 10 mins. this is mentioned in the Microsoft explanation:

"If the status is set to Disabled or Not Configured, the default interval is 10 minutes."

So you actually have to enable it and just set the interval of when it asks you to reboot really high.