There is a point in the build process that the container you are "building" takes over, and starts running commands itself. It is at this point that you are getting the error you see.
The error is due to the client populating it's own apt source list using the mirror you gave it (file://root/ISO/ubuntu-12.04.1-desktop-i386.iso in this case). However, when the client tries to do an apt-get update, it can't, because relative to the client's / there is no /root/ISO/ubuntu-12.04.1-desktop-i386.iso.
To avoid this, simply tell it to copy the apt source list from the server verbatim instead.
The argument you want is --copy-sourceslist.
The full command would be (working off what you listed above):
ltsp-build-client --copy-sourceslist --mirror file://root/ISO/ubuntu-12.04.1-desktop-i386.iso --security-mirror none --accept-unsigned-packages
Also, it was hell finding the commands again, in the end I had to just install LTSP on my workstation and run ltsp-build-client --extra-help. For my own sanity, and other looking for the extra-help message on Google, I'm pasting it here:
From ltsp-server_5.2.16-0ubuntu7:
$ ltsp-build-client --extra-help
LTSP Build Client usage:
ltsp-build-client <options>
Regular options:
--dist set the distribution to be used for install
--extra-help display help for all available commandline options
--help display this help message
--mirror set the mirror location
Advanced options:
--accept-unsigned-packages allow unsigned packages during install
--apt-keys include the listed keys in the apt keyring
--arch set the target architecture
--base set the default base install directory
--chroot set the name of the chroot
--components set the components to be used in mirror
--config load a user specific configuration file
--copy-package-cache cache downloaded packages
--copy-package-lists copy apt Packages files from server
--copy-sourceslist use the servers sources.list instead of generating one
--debconf-seeds load debconf seeding in the chroot after install
--debug enable debug support
--early-mirror add a mirror, which takes priority over the default mirror
--early-packages set the list of packages to install after base-install is completed
--enable-popcon enable popularity-contest in the chroot
--exclude exclude packages from the initial chroot
--extra-mirror add a mirror, with lower priority than the default mirror
--fat-client-desktop run most or all applications locally
--fat-client run most or all applications locally
--http-proxy use specified http proxy
--install-debs-dir install to the chroot all the .deb files contained in the provided directory
--keep-packages keep cache of downloaded package files
--kiosk a simple webkiosk mode
--late-packages list of packages to install as part of the final installation
--locale set the default locale
--ltsp-cluster enable LTSP-Cluster
--mount-cdrom mounts CDROM before installation
--mount-package-cache mount package cache dir from server
--mount-package-dir mount a server directory as the chroot package cache dir
--mythbuntu create a Mythbuntu fat client.
--mythbuntu-user-credentials Mythbuntu: specify login credentials as username:password
--no-guess-proxy do not autodetect apt proxy configuration
--pin-dist distribution to set up apt pinning
--pin-packages list of packages to install from the pinned distribution
--prompt-rootpass prompt to set the root password, defaults to disabled
--purge-chroot purge existing LTSP chroot if present
--security-mirror set the security mirror location
--serial-console enable serial console
--skipimage force to skip the squashfs build (for debian-installer)
--skip-upgrade skip upgrade of installed packages
--tftp-dirs TFTP dirs to update kernel in (space-separated)
--updates-mirror set the update mirror location
