86420,
Man, do I ever hope that I never actually have to feel your pain. Ouch!
I won't even begin to comment on the mechanical aspects, as both Strife, Gilly, and Tomguy know more than I dare to dream about that.
I would try to find out what that reman engine would actually cost with install, and also try to get estimates on the actual job you have at hand. It seems brutally unfair to call you two days later with a "BTW, please to fork over another two grand" request. You might even go on eBay or elsewhere and find 86 420s in good shape that are selling for that price. You can put all the 86 420s in your watch list and know what the final bid price was. Then you can use the Fn and Prnt Scrn keys (located on the bottom of the keyboard, struck at the same time), open up Microsoft Photo Editor, and paste the results to a file you save. I would be willing to bet that you can get that car - in good running condition - with that mileage or lower for under $7000 on eBay if you're patient.
Here's one for starters:
http://cgi.ebay.com/ebaymotors/Mercedes-Benz-400-Series-420-SEL-Mercedes-Benz-1987-420SEL-CLEAN-VERY-NICE-Low-Reserve_W0QQcmdZViewItemQQcategoryZ6331QQihZ020QQitemZ300013662745QQrdZ1QQsspagenameZWDVW
It's an 87 420SEL w/ 164k, but it just had a lot of engine work done,
including a timing chain replacement. It's got a $1500 start price w/ an unkown reserve, and no bids. Put it on your watch list and see what happens: the auction is over in less that 24 hours.
I would then go to him - w/o being a jerk - and ask him to reconsider his price considering what your research reveals. He might lower his labor charges substantially if you can demonstrate that he is unreasonably high, particlarly if you stand firm on what you believe is right and are willing to stand up for yourself in whatever forum is necessary (i.e. arbitration or court). I wouldn't be rude to him at any point, as I certainly wouldn't want a guy who'd be doing that level of work on MY car to be angry at me! But I'd sure want to stand up for myself.
The only other advice I can give you is to blame your wife for this, keep holding it over her head for years to come, and demand lotsa lovin' as compensation. After all, the person who turns on the thing when it self-destructs is clearly completely to blame for the ensuing destruction, right? (I'm Just kidding about the last paragraph; I thought I'd at least try to give you SOMETHING to smile about).
I sure hope this works out for you.