I've replaced the IC, tested all the connections, and the controller is getting 5volts... The console works with other controllers. With the bad controller plugged in to port 2, the controller in port 1 also stops working. It did this with the original IC, and the replacement... Confused?
You could look for connections between pins on the controller. I had a gamecube controller that didn't work despite all connections being there. Turned out the data pin was shorted to ground (probably the cables had cracked inside the cable). Not sure how the NES controller works though.
It seems the NTSC controllers won't work on a PAL console, it needs two resistors added... I found this out just after posting, I assume this is an NTSC controllers.... resistors added! lets see what happens...