Is there a "failsafe" way to restrict internet access from an internet
connection (DSL) to specific websites?

My sister has a DSL connection which she uses for her VOIP phone.
She'd like to connect her computer to the internet as well but is
concerned about all the objectionable content out there. She doesn't
want to leave the filtering in someone else's hands because that
relies on their discretion and not her own. Therefore she needs a
"whitelist" filter where everything will be blocked (domains & IP
addresses) unless it's on the whitelist. The filter should also allow
email through.

Since I have a static IP address on my home computer (different
location from my sister) I thought I could use my computer as a proxy
and then set group policy on her machine to force a proxy connection.
I'm not sure if that would work or if that would only restrict
Internet Explorer.

Also, I've been unable to find an inexpensive proxy that will allow me
to block everything but the whitelist.

What I'm looking for in an answer is (1) a method for solving this
challenge OR (2) an inexpensive or free proxy application that will
allow me to block all traffic except for domains or IP addresses
listed in a whitelist.

If you choose to answer via (2) then please also include instructions
for configuring a Windows XP Pro machine to use a proxy (so that it's
not easily bypassed).

Yes, I believe there is. Open Internet Explorer and click tools
Internet options. If you review the tabs here they allow you to
configure many options for security. Even filter bad sites and allow
good sites.