Ok so here's the deal now... I jacked up a wheel and it spun in 4wd in park with the engine on. Looked at the actuator with a buddy and it moved in and out freely but moved back out kinda slow and had some burrs possibly so it jumps as it is coming out. I emptied the transfer case fluid today. It came out with little chunks of clutch and puddles of clutch dust. Like half a quart came out. Filled it back up with autotrac 2.

 

When you were spinning the front wheel, was the drive shaft spinning or was it still locked? If it was still locked, then the transfer case was doing what it was supposed to be doing and the front axle is not locking in properly.

 

That cable has the same stupid spring-clip in connection on both ends. The end that connects to the actuator and the end that connects to the front diff. If you disconnect the cable from the top, actuator, and pull on it there should be no more then 1/4-3/4 inch both ways. You should also feel it "click". If you do not the connector to the diff. could be popped. When you do this make sure you squeeze the plastic clips and remove the cable completely from the actuator bracket through the hole. The rubber diaphragm is really sensitive to scratches and will tear if you screw around with pliers and the like inside the bracket.

 

The driveshaft was spinning when we had it up off the ground as we turned the wheels.

 

Provided that the 4wd indicator lights are going into the proper modes on the dash & staying there. If the front drive shaft was turning, then the reverse of what I said was true and the conclusion you originally had jumped to was correct; the front axle is engaging correctly and the transfer case is internally screwed. If the same thing can be repeated in 4LO, then the clutch pack is the most likely culprit and you're cheapest route is likely to find a used replacement t-case unless you feel confident in your abilities to rebuild your current one.

I would rather someone spend the time going through the actual steps of verifying that as the case than to hear about them burning through a bunch of money & time replacing the transfer case to find out it was something else entirely later on.

 

I'm already setting up a day to do the transfer case. Probably this Saturday. I will get back to you all as soon as I figure it out. Once again, I appreciate everything you have helped me with.