You have gotten a lot of good information so far. Here's some more.
Water is needed, not only to keep the engine cool, but also cools power
steering fluid, and those rubber hoses between the exhaust riser and
wishbone. The exhaust shutters, and plastic water pickup fitting in the
upper gearcase are also in the path of hot exhaust gasses. Also, the engine
should not be started with the sterndrive in the tilted position. You risk
tearing the u-joint bellow, damaging the gimbal bearing, u-joints, and
possibly the engine coupler. The u-joints, at the very least will make a
very unhappy noise if run at extreme angles.
Look carefully at the coupler splines and the splines on the sterndrive
yoke. If you had an allignment problem, you should see evidence on the
splines. To test for coupling, you will need an old yoke with the u-joint
removed. Hold the coupler in a fixture or mount it on the engine. Put the
yoke in the coupler and a 2' pipe thru the u-joint socket. The coupler
should be able to take at least 200lb torque without slipping. One other
test you might do is to check for runout. I'll let you figure out how to do
that.
You should take the top cover off the sterndrive and make sure everything
looks happy inside.
You should drain all the gear oil and make sure you don't see metal filings
or water.
You should install a new water pump body kit after finding and removing all
broken impeller pieces.
You should make sure the upper gear housing moves freely while feeling for a
bad bearing.Same goes for lower         gearcase,except you need to check
for proper shifting.
You should check for propshaft runout.
I'm sure I left out a lot of details and would hope you have the proper OEM
service manuals to guide you.
Hope some of this information is helpful.
Good Luck
JIMinFL
"Proxy"  wrote in message
news

 Thanks. At this stage I'm not even thinking about rattling/clunking noise.
 When I put the engine together I'll have one more chance to reexamine
 everything. I have the engine hanging on chains and wonder how do I go
 about the coupler. The rest will come later. One thing I know 4 sure that
 2 mechanics have missed the alignment part (or thought that it may be
 ignored for a while and both were wrong). Most upsetting is that I pointed
 that out to both and from that moment became an annoyance. They seemed to
 have no appreciation for other point of view at the moment.
 Now, I've  had a look at the coupler and seen zero damage but.since the
 idea of the coupler is to inject a weak point into the drive system to
 protect crank and drive shafts I wonder where is the breaking point for a
 coupler. If a spun coupler (for a few secs) may still be usable or
 regardless of its look should be replaced anyway. With other words, is
 this enough to spin it just one turn to break the rubber layers bond or
 does it remain good until the spinning visually separates rubber bushings
 (burned, melted rubber would be visible then). Since the engine is
 stripped of exhaust I have to work backwards, start with the coupler, put
 the exhaust, linkage, electrical together and test yoke/u-joint play,
 engine alignment and potentially outdrive issues. Just don't want to put
 it back together to later have to dismantle it again to yank the coupler
 out. I don't feel like going back and forth few times over.
 As indicated impeller is just a cost of testing which I don't mind.
 Otherwise I see no issues with running the engine dry as long as there is
 sufficient lubrication. As I said I've done it several times on different
 engines always successfully without any issues or signs of trouble (no
 need for cooling something that is still cold). But that issue is beyond
 the scope of this subject. Coupler is.
 Btw. Cobra has the best setup allowing impeller removal in just few
 minutes. Very handy, at least in my opinion.
 My take is this: the engine was out of alignment which has caused u-joint
 jamming momentarily and that has caused coupler to let go for a moment
 (blue smoke from the engine compartment - back of the engine - typical for
 coupler failure) and was immediately shut down.
 "Mr Wizzard"  wrote in message
 ...
 "Proxy"  wrote in message
 ...
 damage except for impeller that I have written off anyway for this
 experiment.
 Ah, Ok, I didn't realize that you wrote off the impeller (I missed that)
 (but the rubber smell could be the impeller galling up down there)
 So, you didn't say anything about the U-joints.  And when
 mechanic dude said the yoke "isn't right", whats that mean?
 Wrong one, wrong size, or bad, or what?
 have you peaked inside the outdrive?  bled a little bit of
 grear juice out the bottom of the lower unit to look for
 shavings?  You replaced the coupler, or said that there
 is no visable damage, or difference between that one,
 and the one that was given to you, so I can't see that
 being the problem.  Besides, think about it, there is
 nothing really to rattle there - the spline is a very percision
 fit, and nothing really to rattle.  Things that can rattle a
 connecting rods, pistons, U-joints, yokes, bevel gears etc.
 Could they have missed the shift-shaft lever alignment when
 putting the outdive on? - dog clutch caught between gears?
 Its all a pretty solid chunk of metal down there, so noise
 can be transmitting from anywhere.
 Hate to be stupid here, but are you SURE its not the motor?
 i.e. since your not worried about water, cooling, impellers,
 can you pop the outdrive off, and try to run the motor wihtout
 the outdrive ?  And whats the gimbal bearing look like ?
 The front input shaft bearing for the outdive unit itself ?
 Keep us posted.