That is severe scarring on the sleeve. I think that there are no water leakage issues in the block because it is maintaining water level. I am going to at least continue to take the engine apart - if only to get familiar with it and whether to eventually replace the sleeve, piston and rings. I was quoted by a very reputable local machine shop $140 to replace the liner where I carry him the block and new liner. I had a friend at work look at the pic and he said it looked to him like a lack of lubrication to the #2 cylinder caused it. The valves are intact but look pretty rough so there is some head work.

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Jim