It almost looks like the CStatic doesn't know that it needs to repaint itself, so the background color of the draggable object is left behind. Maybe try to invalidate the CStatic, and see if that helps at all?
Remote debugging is a godsend for debugging visual issues. It's a pain to set up, but having a VM ready for remote debugging will pay off for sure.
What I like to do is set a ton of breakpoints in my paint handling, as well as in the framework paint code itself. This allows you to effectively "freeze frame" the painting without borking it up by flipping into devenv. This way you can get the true picture of who's painting in what order, and where you've got the chance to break in a fill that rect the way you need to.
Thanks for the answers guys, ajryan, you seem to always come up with help for my questions so extra thanks.
Thankfully this time the answer was fairly straightforward....
ImageList_DragShowNolock(FALSE);
m_pDragDropTargetWnd->SendMessage(WM_USER_DRAG_DROP_OBJECT_DRAG_ENTER, (WPARAM)pDragDropObject, (LPARAM)(&dragDropPoint));
ImageList_DragShowNolock(TRUE);
This turns off the drawing of the dragged image, then sends a message to the window being entered to repaint in a highlighted state, then finally redraws the drag image over the top. Seems to have done the trick.