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OK, well Frank is the expert on this system, so hopefully he will chime in….But, there were some changes to this pump system, looks like a copper tube was added in 68 to connect the water pick up to the underside of the water pump, instead of through a passage in the casting like in previous years. You have had the gearcase off, did you notice this extra pick up tube? You mention it is a fresh water engine, but were all the sealing surfaces in good shape? No broken/buggered up little pump screws?
Does it look like the engine has been overheated in the past? Burnt paint, melted wiring?
That two line water pump system is an effort to help warm up the engine sooner and keep it at a constant temperature. When the thermostat is closed, water is forced by that poppet valve and back down to the pump through that second water tube….Recirculating the water in an effort to warm up the water quicker. So, if the poppet valve is missing, inop, water will just bypass the powerhead and return to the pump, causing the engine to overheat. If that poppet valve is jammed shut, this will just delete the recirculating system.
http://www.marineengine.com/parts/johnson-evinrude-parts.php?year=1968&hp=40&model=40802A&manufacturer=Evinrude§ion=Gearcase+Group
http://www.marineengine.com/parts/johnson-evinrude-parts.php?year=1968&hp=40&model=40802A&manufacturer=Evinrude§ion=Powerhead+Group
You mentioned being advised that these engines don’t like being run in a tank, which is correct. You also mention that the gearcase is buried deep enough in the tank to be sure it pumps correctly. If the engine does not show signs of a previous overheat, I would be tempted to advise launching the boat and trying the engine in the water to be sure it is not a tank issue. But, you also mentioned there was no thermostat in place, so it would appear someone before you was chasing an overheat issue.
Are all the pieces of the poppet valve and cup in place, including the seal? Again, if the poppet valve is being bypassed, the water will “short circuit” back to the gearcase without circulating through the powerhead. I suppose you could test this theory by removing the poppet valve/cup, then plugging the return hole with a cork or something…This will delete the recirculation feature and force water through the powerhead…Reassemble the thermostat cap and retest….If the engine seems to run cool now, then we are missing something wrong with the poppet valve system…The return spring has very light tension as I recall, so that is normal. If the engine still overheats, then I think we can safely assume the recirculation system is not to blame.
You have had the head off, and mentioned this is a fresh water engine, so I am assuming all the sealing surfaces/passages looked OK and were not plugged.
Finally, perhaps I should have led with this…Is the water relatively clean in your tank? Perhaps the intake screen is just plugged with crud/debris from your tank….I know, you ran the engine with the cap off and saw decent water flow, so this seems unlikely….I am just being hesitant, because I don’t want you to go nuts trying to fix something that isn’t really broken.