Heman,
No you do not have to be connected to the internet. The Rescue/Recovery process is entirely stand-alone.
I can provide some additional information on my dilemma. As reported above, I went through the entire Factory Restore procedure a second time. I thought I had been successful, but I later discovered that my newly installed ThinkPad did NOT contain the R&R application. Even though the procedure is supposed to restore the machine back to "factory-fresh", it did not.
I spent over two weeks troubleshooting this, and here's what I think happened.
When the Factory Restore procedue runs, one of the many many installers that it runs is the installer for the R&R application. It is attempting to install R&R onto the C: drive. In doing so, it appears to look inside the hidden IBM partition (SERVICE001) to decide if it needs to update the software that is there. If it finds a newer version of the R&R software on the hidden paritition, I believe the installer fails. As a result, you are left with a "new" ThinkPad, but it's missing the R&R application, which means you can't do any backups for recoveries.
What I ended up doing was using EASEUS Partition Manager to reformat the SERVICE001 partition. It's a free downloaded partition manager. Once the SERVICE001 partition was empty, I booted from the Recovery CD, and went through the entire Factory Recovery installation again, loading all of the 6 CD images. At the end of the recovery, I left the 6th CD in the drive. I'm not sure if this is important or not. The system rebooted into the special R&R recovery environment which had been reinstalled onto the SERVICE001 partition. After the reboot, it then continued with the recovery process on its own. A pop-up appeared "Recovering your system. Please wait...". Fifteen minutes later, it rebooted again. Now, I saw thousands of lines of code flashing by in what looked like a DOS window. The recovery process is running hundred of scripts as it expands, installs, and configures everything. The overall process took another hour, during which time it rebooted at least 6 more times.
This was all unattended (i.e. no human intervention).
Two full hours after I had first booted from the R&R boot CD, a nice new Windows XP start-up window appeared. In my case, it was WinXP SP2, since that is what was on my original system. At this point, I ejected disc 6 of the R&R recovery set.
But don't stop now. There's so much more to do.
I first made an image backup of the brand-new C: partition and the SERVICE001 partition. I don't ever want to have to go through this again. If you don't already have a good backup program, download a copy of Macrium Reflect (free), preferably on another system that is already running. Put it on a USB drive and copy it to your fresh ThinkPad. Then use it to backup C: and SERVICE001 onto an external USB drive.
Now you can plug the ThinkPad into your LAN. The first thing I did was disable Norton Anti-virus, so it won't get in the way of any of the subsequent updates.
Next I ran the IBM System Update utility. The first thing it found out of date was itself! It downloaded and installed the latest Lenovo System Update, which I think was 3.14.0019.
Next I ran the new System Update. It downloaded/installed about a dozen fixes and patches from IBM/Lenovo. After SU had brought the system up to date, I ran Reflect again and made another copy of C:.
One component that SU did not update was R&R. The system still had R&R with Ultra Restore V1.0 on it -- that's what came from the factory when I got the T42. You'll probably want to update R&R to the latest. WARNING - be sure to get the right version. If you have a T42, the latest supported version is 3.1. The installer is tvtrnr31, found on the Lenovo web site. Do not install R&R V4 or higher on a T42 unless you want to risk having to do this all over again. I removed the older version 1.0 of R&R before installing the new package (using Add/Remove Programs). May not be essential, but it can't hurt.
If you have a newer ThinkPad, you might be able to use a more recent release of R&R. Read the IBM Release Notes carefully.
WARNING - some of IBM's posted compatibility information about R&R is incorrect. I found a 'bug' in their documents which led me to think that I could run V4 on my T42. They have since corrected their on-line documents.
Now it's time for SP3. I went off to the Microsoft support website, searched around and found the WinXP SP3 updater (in ISO format). I downloaded the update, burned a CD, and applied the SP3 update from the CD. Actually, I made the CD long before I started this recovery procedure. I wanted to have it available when I got to this point in the process. You could try doing SP3 via the Windows Update website, but a chap at IBM support recommended I do it via the download.
After SP3 was installed, I then went to the Windows Update website, and let it update the system with the dozens of security patches and other fixes that have issued since SP3 came out. After that was done, I used Reflect to backup the C: partition again. This effectively is my 'gold disc' for subsequent disaster recovery.
Finally, (I think this is the last step), I downloaded and/or installed useful programs like Firefox, Safari, iTunes, Sandboxie, my VPN client, MS Office, Jungle Disk, and various other bits. All told, this took me the better part of a weekend. But I now have a nice, clean, speedy ThinkPad, and I haven't had a BSOD yet!
Good luck getting your ThinkPad back on the air.