I was at a client site today and we were experiencing the following problem:
When you create a sub-site underneath the home site and use say the 'Team Site' template, switching to the home site and applying a Site Master Page (with the children inherit option checked), this new site does not inherit the change. When you navigate to the new team site it complains saying 'The system master page setting currently applied to this site is invalid. Please select a new master page and apply it'.
The answer is:
All WSS templates that are also included in MOSS (including pages) actually inherit their setting from the System Master Page setting, not the Site Master Page setting. The Site Master Page is not used. Only in MOSS-specific templates, such as a Publishing site, is there Site Master Page usage and System Master Page usage. So to fix this, from the home page Master page settings page, select 'System Master Page' select the master page you want and check the 'Reset all subsites' option.