Chaz 58, here is a link to the engine section of the 1960 shop manual--

http://www.canadianmilitarypattern.com/1960%20235-261%20Engine%20Manual.htm

As I recall, the dowel in the 'out' position is recessed between 1/32" and 1/16" in the hole. It is not flush with the outer edge. The two 261's I have in the shop have both the 1/8" and the 1/2" threaded holes in the block under the dowel. The dowel must either be all the way in or all the way out.

When you insert the dowel, you reverse the plumbing for the filters. With the dowel in the out position, you can plug all the holes and not run a filter. Or you can run a bypass filter. It must have a 1/16" restriction somewhere in the filter or in the lines. Using a full flow filter without a restriction will starve the bearings of oil. The same is true with a 235; most bypass filters have the restriction on the oil tube inside the canister.

The bypass circuit runs from the back port where the gauge connects to the 1/8" port (that you don't have) under the dowel. The 1/8" port is not connected to the oil galley and simply dumps the oil into the sump. Others can chime in, but you also might be able to connect the return to the 1/2" hole under the dowel, but I am not sure how that would work since it connects to the pressurized galley. The routing is the same direction as a 235.

In full flow mode with the dowel pushed in, the circuit is reversed. The 1/2" port under the dowel becomes the feed for the full flow filter and the 1/2" port at the back of the engine (oil pressure gauge) is the return. If no filter is used, these two ports need to be piped together because the dowel blocks the galley...they must be plumbed together with or without a filter.

If you spin the engine with your dowel in the out position, you should get oil out of both the front and back 1/2" ports because they are both pressurized and are not blocked. To test your theory about being set up for full flow with the dowel out, yes, you would get oil out of the front port when spinning the engine but not the back IF everything else works like a normal 261.

Hope this helps,

Matt