How does Windows actually detect LAN (proxy) settings when using Automatic Configuration
Solution 1:
Its simple: Browsers (Firefox works the same) query GET http://wpad/wpad.dat.
If a web server named wpad is resolveable, it should serve wpad.dat, a script file analog to netscape PAC files. MIME type must also be "application/x-ns-proxy-autoconfig".
Solution 2:
This info about WPAD (Web Proxy Auto Discovery) seems to describe the process in detail, though I have confirmed that what Tomalak says is also actually occurring.