Can't say cause I'm not there to see the problem first hand, just my reasoning. With hubs locked everything up front is turning and no noise. With drive shaft in and hubs locked everything is turning and you have grinding sound. Difference there is the drive shaft, so that's what I would look to as causing the problem. It is possible that the the diff itself is damaged and is only showing up when the shaft is in, but from other members breakage stories I think that the differential is about the last thing that would break. If the differential did get damaged something caused that to happen, most likely binding, which brings us right back to being lowered too much.
IIRC you mentioned you had the front drive shaft shortened. While I am in process of doing a 5.0 swap on a 2wd, I've never done or been around one on a 4wd. I would have though that the front drive shaft would need lengthening and the rear shortened.