Just this weekend I experienced a similar problem. Water stopped comming out of the pee hole. Instead of water coming out, warm air came out with a slight component of blue smoke.
Once the engine started it would run fine for about 20 minutes. It then would show signs of loosing power. Also, white smoke or steam seemed to rise from the water in place of the usual thin light blue smoke.
I took off the coolant plate on the power head, and turned the engine over without spark plugs with the earmuff flusher with water running through it. Water gushed out of the bottom below the outside of the the lowest cylinder. I assumed maybe the gasket blew, so I replaced it, expecting to solve the problem. Replacing the gasket did not change anything. It seems that though water came up from the lower unit, there was not enough pressure for the water to make it to the top cylinder.
Also noticed whitish sludge coming out of bottom spark plug hole, when turning engine over without spark plugs.
I checked the compression. It was around 100 for each cylinder, while the engine was cold.
Any thoughts?
