Is it possible to not cache windows updates on the WSUS server AT ALL (because updates take up so much disk space) and have clients retrieve them from internet based update servers (updates will be cached on clients using Delivery Optimization) while at the same time specifying which updates clients can or cannot install by approving/declining updates on the WSUS server? If so, what group policy settings must be set to make this happen?
It's not a Group Policy. It's a WSUS configuration. Access the WSUS MMC, select Options in the left-hand navigation pane. In the right pane, select the menu option Update Files and Languages, then the radio button for Do not store update files locally; computers install from Microsoft Update. Press OK to save.
However, since you are changing the setting for where updates are obtained, be sure to review the GPO setting Computer Configuration > Policies > Administrative Templates > System > Internet Communication Management > Internet Communication Settings > Turn off access to all Windows Update features as well as the GPO setting Computer Configuration > Policies > Administrative Templates > Windows Components > Windows Update > Do not connect to any Windows Update Internet locations to ensure that the computers are allowed to communicate with the internet Windows Update.
*Note: depending upon your domain schema level, those GPO items may not exist.