a 2004 has live hubs, they don't disengage-ever. the front diff is always turning with the wheels. the only front disconnect is inside the transfer case.
the transfer case has 2 separate shift mechanisms inside. one slides the range reduction from hi to low, in the process of that is a neutral spot that gets passed over.
that would put all 4 wheels in neutral if it got stuck there.
the other engages the chain/front driveshaft, at that point the rear driveshaft is always engaged to that mechanism.
if it slips the rear stays powered, the front loses power.
both mechanisms are powered by the same shaft via the shift motor. the shift forks are spring loaded so the motor rotating the shaft
only tells it to attempt to shift, the actual shifting happens when the gears align and the springs push the shift forks to engage.
that could possibly explain the front dropping out. if it doesn't engage fully and pops out the springs will attempt to push it back in.
check out this thread, download the manual.
the cases listed are earlier than yours, the front outputs are different, the internals are the same
Warner Gear 1350 -1354 Manual found | The Ranger Station