Here is an update. This appears to be a permissions issue with xp. You must have full administrator rights for drag and drop to work when connected to an mc14 server.
I login to my computer with my name which is supposed to have 'administrator' rights. My name login has the same password as the actual Administrator password. If I switch users and login as Administrator, drag & drop works. Switching users back to me again, no. But if I right-click and choose Run As and run mc14 as Administrator, then drag & drop works while connected to an mc14 server logged in the os as me.
I have tried like the devil to reset all permissions in xp but no luck. This solution helped a lot of people almost like the second coming but did not work for me -
http://www.winhelponline.com/blog/reset-the-registry-and-the-file-permissions-in-windows-xp/ .
If anyone has another suggestion for resetting permissions, great, if not, at least I hope I shed some light on strange behavior while connected to an mc14 server.