The Council is only applying the regulations about housing benefit. Clearly this is very difficult in the situation you set out, but imagine the probelms that would arise & the ability of people to milk the system if it was possible to get HB when living in a property owned by another family member.
The only solutions I can suggest are:
1. Continue as now - i.e. go on renting together
2. The unemployed on gets HB to rent elsewhere. It is quite possible to get confirmation that HB will be paid before entering into a tenancy agreement & the Coucil HB Dept. should be able to explain how to do this.