lost my iphone 5 just before xmas, had the replacement sent from my insurance claim, few days back it was handed in to a local shop i left my number with, a little worse for wear, should i let the insurance company know , its blocked so not much good to anyone in this country

If you don't let the insurance company know, that's technically fraud.

They could decide that any number of things should happen. It's not completely unheard of for them to let you keep both phones.

You must let the insurance company know if you want to stay on the right side of the law as has been said. They may just let you keep it especially if it's IMEI barred.
However, you can call the network that barred it and threre's no reason why they can't unbar it for you if you explain what's happened. It's a fliipin expensive paper weight otherwise
Once it's IMEI is unbarred you could stick a PAYG sim in it from the same network or call the network again and get it unlocked to use on any network.

Can you still use it as an "iPod Touch" if its IMEI is barred?

Obviously once you'd told the insurance.

I'd say so yeah, but it would make more sense to get it unbarred and unlocked and then sell it, you can get 400-500 depending on condition