There is a rigid polyisocyanurate foam core insulation, often sold under the brand name Super Tuff from Dow that has a higher R value than XPS. It is R-13 in 2 inch panels and is higher if you trap a small air barrier behind it (around R-15).
The foam has a foil vapor barrier on the back.
You could
- mount this on the existing furring foil side out, using glue and screws
- seal the edges with foil tape
- reinstall paneling with glue and screws throught the foam, into the existing furring.
HOWEVER: The paneling could hold itself up when mounted this way, and you could mount lighweight things, such as pictures. The walls would NOT be suitable for mounting shelves, fixtures, heavy mirrors, etc. You would need to take care and inform any subsequent owner that the walls were not intended for bearing any signifciant weight!
Drylock is of questionable benefit, IMHO. It's definitely not a solution to a leaky basement...but it sounds like you've done some regrading already which should help with that.
The reason basements are often musty isn't so much from water from the outside but condensation. Basements are humid and cool, so the walls tend to be perpetually wet. The goal, then is to insulate the walls so help prevent that moist air from hitting the cool wall.
When using fiberglass, that's permeable to the air, so the solution is traditionally to put up a plastic vapor barrier. However, if water does leak in from outside, you've now trapped it.
As such, I strongly recommend going with the Building Sciences corporations recommendation of using XPS foam board against the wall and no additional vapor barrier. The XPS acts as a moisture retarder, yet will let moisture eventually dry through from one side to the other.
I went in to much more detail (including my recommendation to use metal framing rather than wood) with this answer here: https://diy.stackexchange.com/a/8644/1209
When finished, the other objective is to try and reduce the humidity in the basement. If you can bring the basement space into being part of the conditioned space, that's ideal. Alternatively, keep that dehumidifier running.
To answer the specific questions:
Is drylock sufficient to use R-15 batt? Or should I skip it entirely?
In terms of creating an insulated finished space, Drylock is of no use. The purpose of a vapor barrier is to prevent moist air from getting to a surface to condense on. The concrete wall will still be cool regardless of Drylock.
If not then should I put in EPS/XPS? (again Drylock?)
Yes to the EPX/XPS (see my linked answer above).
Would I really need more than that?
Code should dictate what is required. Check your local authorities regarding the amount of insulation you need. EPX/XPS will get you more R-value per inch than fiberglass.
In terms of comfort, the biggest culprits in a basement will be air infiltration, the upper exposed part of the foundation, and the space between the floor joists. Focus on those as well.
Best Answer
You might as well just remove the stud and small section of plate that contacts the wall. this will allow you to completely insulate the wall and the stud can be re-installed outside the insulation and screwed into the upper and lower plates if you cut them correctly. This will also come in handy when you go to put walls against the insulated concrete. The existing stud will be here you can corner to it with extra sheathing studs and make a proper corner. Canadian codes are very strict, so do it right the first time.