Looks like the answer was simple yet obscure; I had an app setting (a password), which contained a “>” symbol. I tried converting the app to .NET 4 then back to .NET 3.5 and everything ran fine as during the process the symbol had been escaped to “>”. Never had a problem with this character until config transformations came along but at least the fix is now simple.
Edit: blogged about in a bit more detail: Visual Studio 2010 Config Transformations TransformXml task failure