Mr Toad,
Think Pinhead is correct. Any relative movement between the shaft and the gear acts like a pump. The high speed output gear bushing is probably worn as well adding to the rocking motion of the input gear on coast and drive.The seal surface looks pretty good from your picture. You can put the seal in, at a slightly different depth in the case and have the seal lip run on the undisturbed surface of the gear.
Have been meaning to try a product from the Belzona range of products.
Products - Belzona Think with reasonably good shaft splines and reasonably good gear splines and some of the Belzona 1121 super metal it might take up the slack. ( good meaning slightly worn splines from from 30 or 40 years of use) Anybody try this stuff or have experience?
Have been thinking of doing write-up about the transfer case and all the little problems that they have. Gear noise, oil leaks etc. Basically how to blue-print a one piece transfer case. It would be good to get input from all the knowledge base out there, and compile a sticky to pass it on.
Thanks jb