I see the same problem, in a repeatable way. I upgraded from 9.04 to 9.10. The ssh server was configured to allow X11 forwarding:

$ cat /etc/ssh/sshd_config | grep X11
X11Forwarding yes
X11UseLocalhost yes
X11DisplayOffset 10

When I connect from another machine using the PuTTY ssh client, I can login just fine, no errors, but the DISPLAY environment variable is not set. The auth_log shows "error: Failed to allocate internet-domain X11 display socket."

Nov  3 18:54:11 localhost sshd[29852]: debug1: Forked child 11013.
Nov  3 18:54:11 localhost sshd[11013]: debug1: rexec start in 5 out 5 newsock 5 pipe 7 sock 8
Nov  3 18:54:11 localhost sshd[11013]: debug1: inetd sockets after dupping: 3, 3             
Nov  3 18:54:11 localhost sshd[11013]: Connection from 9.2.19.64 port 16059                  
Nov  3 18:54:11 localhost sshd[11013]: debug1: Client protocol version 2.0; client software version PuTTY_Release_0.60
Nov  3 18:54:11 localhost sshd[11013]: debug1: no match: PuTTY_Release_0.60                                           
Nov  3 18:54:11 localhost sshd[11013]: debug1: Enabling compatibility mode for protocol 2.0                           
Nov  3 18:54:11 localhost sshd[11013]: debug1: Local version string SSH-2.0-OpenSSH_5.1p1 Debian-6ubuntu2             
Nov  3 18:54:11 localhost sshd[11013]: debug1: list_hostkey_types: ssh-rsa,ssh-dss                                    
Nov  3 18:54:11 localhost sshd[11013]: debug1: SSH2_MSG_KEXINIT sent                                                  
Nov  3 18:54:11 localhost sshd[11013]: debug1: SSH2_MSG_KEXINIT received                                              
Nov  3 18:54:11 localhost sshd[11013]: debug1: kex: client->server aes256-ctr hmac-sha1 none                          
Nov  3 18:54:11 localhost sshd[11013]: debug1: kex: server->client aes256-ctr hmac-sha1 none                          
Nov  3 18:54:11 localhost sshd[11013]: debug1: SSH2_MSG_KEX_DH_GEX_REQUEST_OLD received                               
Nov  3 18:54:11 localhost sshd[11013]: debug1: SSH2_MSG_KEX_DH_GEX_GROUP sent                                         
Nov  3 18:54:11 localhost sshd[11013]: debug1: expecting SSH2_MSG_KEX_DH_GEX_INIT                                     
Nov  3 18:54:12 localhost sshd[11013]: debug1: SSH2_MSG_KEX_DH_GEX_REPLY sent                                         
Nov  3 18:54:12 localhost sshd[11013]: debug1: SSH2_MSG_NEWKEYS sent                                                  
Nov  3 18:54:12 localhost sshd[11013]: debug1: expecting SSH2_MSG_NEWKEYS                                             
Nov  3 18:54:12 localhost sshd[11013]: debug1: SSH2_MSG_NEWKEYS received                                              
Nov  3 18:54:12 localhost sshd[11013]: debug1: KEX done                                                               
Nov  3 18:54:12 localhost sshd[11013]: debug1: userauth-request for user USER service ssh-connection method none     
Nov  3 18:54:12 localhost sshd[11013]: debug1: attempt 0 failures 0
Nov  3 18:54:12 localhost sshd[11013]: debug1: PAM: initializing for "USER"
Nov  3 18:54:12 localhost sshd[11013]: debug1: PAM: setting PAM_RHOST to "mgebeleizis.watson.ibm.com"
Nov  3 18:54:12 localhost sshd[11013]: debug1: PAM: setting PAM_TTY to "ssh"
Nov  3 18:54:12 localhost sshd[11013]: Failed none for USER from 9.2.19.64 port 16059 ssh2
Nov  3 18:54:12 localhost sshd[11013]: debug1: userauth-request for user USER service ssh-connection method publickey
Nov  3 18:54:12 localhost sshd[11013]: debug1: attempt 1 failures 0
Nov  3 18:54:12 localhost sshd[11013]: debug1: test whether pkalg/pkblob are acceptable
Nov  3 18:54:12 localhost sshd[11013]: debug1: Checking blacklist file /usr/share/ssh/blacklist.RSA-4096
Nov  3 18:54:12 localhost sshd[11013]: debug1: Checking blacklist file /etc/ssh/blacklist.RSA-4096
Nov  3 18:54:12 localhost sshd[11013]: debug1: temporarily_use_uid: 1000/1000 (e=0/0)
Nov  3 18:54:12 localhost sshd[11013]: debug1: trying public key file /home/USER/.ssh/authorized_keys
Nov  3 18:54:12 localhost sshd[11013]: debug1: fd 4 clearing O_NONBLOCK
Nov  3 18:54:12 localhost sshd[11013]: debug1: matching key found: file /home/USER/.ssh/authorized_keys, line 1
Nov  3 18:54:12 localhost sshd[11013]: Found matching RSA key: db:9b:cd:71:f5:e2:54:23:29:2b:66:55:ec:2a:d6:1a
Nov  3 18:54:12 localhost sshd[11013]: debug1: restore_uid: 0/0
Nov  3 18:54:12 localhost sshd[11013]: Postponed publickey for USER from 9.2.19.64 port 16059 ssh2
Nov  3 18:54:17 localhost sshd[11013]: debug1: userauth-request for user USER service ssh-connection method publickey
Nov  3 18:54:17 localhost sshd[11013]: debug1: attempt 2 failures 0
Nov  3 18:54:17 localhost sshd[11013]: debug1: Checking blacklist file /usr/share/ssh/blacklist.RSA-4096
Nov  3 18:54:17 localhost sshd[11013]: debug1: Checking blacklist file /etc/ssh/blacklist.RSA-4096
Nov  3 18:54:17 localhost sshd[11013]: debug1: temporarily_use_uid: 1000/1000 (e=0/0)
Nov  3 18:54:17 localhost sshd[11013]: debug1: trying public key file /home/USER/.ssh/authorized_keys
Nov  3 18:54:17 localhost sshd[11013]: debug1: fd 4 clearing O_NONBLOCK
Nov  3 18:54:17 localhost sshd[11013]: debug1: matching key found: file /home/USER/.ssh/authorized_keys, line 1
Nov  3 18:54:17 localhost sshd[11013]: Found matching RSA key: db:9b:cd:71:f5:e2:54:23:29:2b:66:55:ec:2a:d6:1a
Nov  3 18:54:17 localhost sshd[11013]: debug1: restore_uid: 0/0
Nov  3 18:54:17 localhost sshd[11013]: debug1: ssh_rsa_verify: signature correct
Nov  3 18:54:17 localhost sshd[11013]: debug1: do_pam_account: called
Nov  3 18:54:17 localhost sshd[11013]: Accepted publickey for USER from 9.2.19.64 port 16059 ssh2
Nov  3 18:54:17 localhost sshd[11013]: debug1: temporarily_use_uid: 1000/1000 (e=0/0)
Nov  3 18:54:17 localhost sshd[11013]: debug1: ssh_gssapi_storecreds: Not a GSSAPI mechanism
Nov  3 18:54:17 localhost sshd[11013]: debug1: restore_uid: 0/0
Nov  3 18:54:17 localhost sshd[11013]: debug1: PAM: establishing credentials
Nov  3 18:54:17 localhost sshd[11013]: pam_unix(sshd:session): session opened for user USER by (uid=0)
Nov  3 18:54:19 localhost sshd[11013]: debug1: Entering interactive session for SSH2.
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_init_dispatch_20
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_input_channel_open: ctype session rchan 256 win 16384 max 16384
Nov  3 18:54:19 localhost sshd[11013]: debug1: input_session_request
Nov  3 18:54:19 localhost sshd[11013]: debug1: channel 0: new [server-session]
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_new: session 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_open: channel 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_open: session 0: link with channel 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_input_channel_open: confirm session
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_input_channel_req: channel 0 request x11-req reply 1
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_by_channel: session 0 channel 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_input_channel_req: session 0 req x11-req
Nov  3 18:54:19 localhost sshd[11013]: error: Failed to allocate internet-domain X11 display socket.
Nov  3 18:54:19 localhost sshd[11013]: debug1: x11_create_display_inet failed.
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_input_channel_req: channel 0 request pty-req reply 1
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_by_channel: session 0 channel 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_input_channel_req: session 0 req pty-req
Nov  3 18:54:19 localhost sshd[11013]: debug1: Allocating pty.
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_pty_req: session 0 alloc /dev/pts/3
Nov  3 18:54:19 localhost sshd[11013]: debug1: SELinux support disabled
Nov  3 18:54:19 localhost sshd[11013]: debug1: server_input_channel_req: channel 0 request shell reply 1
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_by_channel: session 0 channel 0
Nov  3 18:54:19 localhost sshd[11013]: debug1: session_input_channel_req: session 0 req shell
Nov  3 18:54:19 localhost sshd[11088]: debug1: Setting controlling tty using TIOCSCTTY.
Nov  3 18:54:19 localhost sshd[11088]: debug1: PAM: reinitializing credentials
Nov  3 18:54:19 localhost sshd[11088]: debug1: permanently_set_uid: 1000/1000

The same PuTTY client can connect to a machine runnig Jaunty and get X forwarding runs just fine.