Installing in SSHD_SERVER + privilege separation mode. I also set privilege separation to "yes" in the config manually. This didn't work for me for a lot time, the user didn't get created. Then it worked, I don't know why. I only went to user accounts in control panel to check that UAC is off. I also had /var/empty with full access for everyone.
For C:\openssh\var\empty I've set "attributes get/set" permissions to Everyone and myself and "full" permissions to .\sshd_server. I also made it the owner.