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these are my steps for installation

$chgrp Administrators /var/run
$chgrp Administrators /var/log
$chgrp Administrators /var/empty
$chmod 775 /var/run
$chmod 775 /var/log
$ssh-host-config
[...]
*** Query: Enter the value of CYGWIN for the daemon: [] ntsec binmode nodosfilewarning
[...]

$ chown cyg_server /var/empty
$ chmod 755 /var/empty

$editrights -a SeTcbPrivilege -u cyg_server
$editrights -a SeAssignPrimaryTokenPrivilege -u cyg_server
$editrights -a SeCreateTokenPrivilege -u cyg_server
$editrights -a SeIncreaseQuotaPrivilege -u cyg_server
$editrights -a SeServiceLogonRight -u cyg_server
$editrights -a SeDenyRemoteInteractiveLogonRight -u cyg_server

$chmod +r /etc/passwd
$chmod u+w /etc/passwd
$chmod +r /etc/group
$chmod u+w /etc/group
$chmod 755 /var
$touch /var/log/sshd.log
$chmod 664 /var/log/sshd.log
$editrights -l -u cyg_server
SeTcbPrivilege
SeAssignPrimaryTokenPrivilege
SeCreateTokenPrivilege
SeIncreaseQuotaPrivilege
SeServiceLogonRight
SeDenyRemoteInteractiveLogonRight

the windows event log states

Accepted password for local_user from 127.0.0.1 port 52018 ssh2
Received disconnect from 127.0.0.1: 11: disconnected by user

however for admin accounts it states

Accepted password for admin_user from 127.0.0.1 port 52023 ssh2
error: setreuid 1001: Operation not permitted
Received disconnect from 127.0.0.1: 11: disconnected by user

the ssh terminal always shows:

$ ssh admin_user@127.0.0.1
admin_user@127.0.0.1's password:
Last login: Wed Sep 16 15:38:44 2015 from 127.0.0.1
...
Connection closed by 127.0.0.1

and with -v -v -v it ends with

debug1: Offering RSA public key: /home/admin_user/.ssh/id_rsa
debug3: send_pubkey_test
debug2: we sent a publickey packet, wait for reply
Connection closed by 127.0.0.1
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it's hard to believe but the issue was that I used 127.0.0.1 instead of the actual ip address of the physical network interface.

and now it works from either ip address...

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