If you use MS Proxy 2.0, the DNS field should always be blank in WINIPCFG, as Proxy handles name resolution for you. Using a DNS entry with Proxy will slow name resolution, or it might not work at all.
The DNS field therefore, if using Proxy, should be left blank on the client's PC TCP/IP>DNS properties.
The Proxy server's DNS entry, though, must point to a valid DNS server, usually a local caching server. If you run Primary DNS, caching is already there. Proxy and DNS can reside on the same server.
Make sure the DNS Forwarders point to another, valid DNS server, usually from your ISP, or you won't get your cache populated.
If not using Proxy, set the client PC's TCP/IP>DNS property to point to a valid DNS server. Preferably, you can set this in DHCP instead.
Finally, query the target DNS server using the command line utlity, or something like Cyberkit, to make sure it will answer queries properly. These servers *do* go down sometimes, which is why you can, and should, specify fallback servers in the client, caching, or Primary, as appropriate. A failed DNS forward-query will show up in Event Viewer.