I have finally found a solution that works for me…
Disable the Enhanced USB Driver in Device Manager and plug in your iPod – and then click Restore… it works just fine.
Just about to try it on another machine, but it definitely looks like the solution!!!
I have wasted about 2 days on this… and didn’t get much sleep last night either trying various solutions.
Obviously the problem is an issue with the USB driver for the USB 2.0 ports on the PC… with the Enhanced Controller disabled, the iPod will restore. Once it is restored, just re-enable the controller.