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96 GTI died on me on the water, what could it be?

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Thanks for the in-depth reply. I will get a new engine then. What about the flywheel and stator housing, should I get some clean parts off ebay? I didn't know if all that rust is bad news down the road. Shouldn't it be clean and nice in there versus the crap hole that it currently is?
 
Well I bit the bullet and ordered a new motor from SBT. I've already been through the jet pump (oil change/wear ring) and electronics, so I figured I'd look on the bright side and make this a really nice ski.

All the accessory engine bits look like crap or are rusted pretty good, so I ordered a "new" (by new I mean good used condition) pto, flywheel, stator case/cover, stator, intake manifold, carb cleaning kit, and HD carbon seal kit. I'm gonna degrease the interior and replace the oil lines/filter (keeping the oil pump, I believe in Dr. Honda on this).

I'll post some pics when I've gotten it all in. Thanks for the help diagnosing all this!
 
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