Thanks for the reply Kurapica but the VPC image is 32bit XP and this was happening with other debuggers also. The problem seems very similar the trap flag issue of Olly v1 tho. Very odd and no problems running a debugger on the host.
It could be related to MS update kb2830477 but I have not tested. I just read about this update before the holidays and several people have reported problems with it and VPC. Currently I have put in a new hard drive for the host, installed clean OS and running VMWare without any problems. No plans to install VPC ever again.
VMWare is running XP so much faster.
I still have the drive with the old install. Next time I need to boot up into that system, I'll check if that KB was causing the problem. If success I'll post back.