The Basement Wall Is 4 ft concrete & A 3/1/2 ft pony wall or I call it a knee wall (3/1/2 ft wood on top of concrete).The concrete wall is 5 inches wider than the pony wall.How do I frame & insulate this complicated wall ? I can put a wall up against the concrete to the floor joist , but I will have a 5 in or so space inside of it,please explain the best way to do this... THANK-YOU.

That is how most do it or just frame the bottom concrete wall and leave a shelf

I usually frame to the top of the concrete and make a shelf its less lumber and if you have windows in the knee wall it will be easier to trim them out.

If you would prefer to have flat walls with no shelf just fill that extra space with http://www.dow.com/PublishedLiterature/dh_003c/0901b8038003c56f.pdf?filepath=styrofoam/pdfs/noreg/716-00150.pdf&fromPage=GetDoc I also use it on the walls and floor. Glue it in place, tape the seams and add a sub floor and stud wall.

Sounds like the basement floor was dug out lower than the footer. Hope it wwas done correctly.

I'd just stud in front of the widest portion