WSUS downloading updates when "Do not store updates locally" is set.

That's not expected behaviour if you've selected Do not store update files locally; computers install from Microsoft Update, there's no hidden setting that you're missing.

Couple of things you could try:

• Restart WSUS Service / restart server
• Delete all files and folders under WSUScontent then run C:\Program Files\Update Services\Tools\WSUSutil.exe reset ("Checks that every metadata row in the database has corresponding content stored in the file system. If content is missing or corrupted, WSUS downloads the content again. This is useful after restoring a database.")
• There's a few patches for WSUS 4.0 - notably MS KB 2938066 and 3159706 (although they don't appear very relevant to your interests / issues)

Beyond that I think you're looking at rebuilding (preferably on 2012 R2)

Note - Setting 'do not store updates locally' after the fact won't automatically purge updates already downloaded