Thanks for the detailed reply.
I did a bit of digging into this today. I blocked the Live ports on my router and enabled the firewall log. When I booted my 'online' console with a Live gamer profile, of course the console could not connect to Live and the firewall log was littered with entries of the attempt to connect and the firewall stopping it.
I did the same on my modded console (which makes use of the Block Access to Live feature in the Family settings) and used my same Live gamer profile (on memory card). I specifically tried to log onto Live from the dash and I get the message 'Family settings are blocking Live access blah blah...'
The firewall log recorded no entries what so ever from the console IP address. It made no attempt to even connect to Live with the family settings in place. I played some COD5 and kept checing the log...nothing.
Nice to know

Once again, thanks for the reply mate.
if you have trouble with it in the future, just give your xbox a good ip setting, but a bad default gateway and dns. this will mean that your system will be addressable, and should be able to see machines your network, but it won't be able to resolve external domain names, and even if it could, it won't be able to send traffic outside your network