Hello can someone tell me the best way to make a XP master image using WDS? I'm using and an optiplex 760 for the base image. Should I add the drivers for all our models into the sysprep file before the capture or can I use depolyment workbench to inject drivers into the .wim image?

You should consider using a Microsoft tool designed to be more suitable for this particular job (image creation/maintenance), like MDT 2010.

I have MDT 2010 update 1 installed. Does it allow me to add local security policy settings and desktop configurations? Can I edit xp .wim images with it?

You can't edit the WIM files like you can Vista or Win7 (adding things offline, servicing, etc). An XP install is locked once sysprep'ed, but if you mean mount it and add or remove files, edit registry, etc, then yes. As to local policy, use Security Compliance Manager (works for XP SP3 and higher) to create and apply local policy settings.