Recently I inspected my differentials and found what I believe is water in my front diff. While the transfer case and rear differential had nice clear oil, the oil in the front diff looked like grey gravy, it was thick like sludge.

Grey oil is a dead giveaway that you have water contamination. You will have to drain it immediately and change it again after a few days running.

Problems that may arise are rust and pitting of stressed components and bearings. You'll need to keep an eye out for any notchy patches as you turn the driveshaft by hand.

I have heard george mention different colors of lube indicating different conditions inside the front axle.

Other than the grey colour indicating water, you also need to look out for excessively black diff oil in the front end. Black oil indicates that the axle seals are leaking and you are getting black moly grease from the steering knuckles into the housing. The danger here is that the oil is also mixing with the grease in the steering knuckles which will lead to wearing of the knuckle.

I drained the front diff and re-oiled it with 80w-90 which is the spec for cold (< 0 degrees F) but should be ok for normal temperatures as far as I can tell.

Make sure that any oil in the rear end is compatible with a friction type limited slip diff.

I also spent Saturday extending my differential breather hoses.

It appears that the vent tube for the transfer case and the transmission joins with the transmission dipstick tube (this is on a '94). It's hard to tell because of space limitations. I couldn't find any other tubes that looked like vent tubes on the transfer.

This may be for an auto (can anyone check?). On a manual box, the breather sits on the bell housing and is quite difficult to get to.

Another question regards lubing the steering knuckles. We removed the plug with the 13 mm square fitting and stuck in a tweezers to look at the grease in there. It came out with what may be the same sludge we drained out of the diff. Perhaps this indicates the seal between the diff oil and the steering knuckle grease is letting oil into the steering knuckle.

Yuk. You obviously have water in the knuckles as well. It's hard to tell whether the water came in from the housing. You'll need to run clean oil and grease for a while to check. In any case, if it's as bad as you indicate, you may need to pull the knuckles apart and clean the water contaminated grease from the knuckles.

What can often happen is that you enter water with a hot diff housing and the sudden quenching creates low pressure in the housing. The factory flapper breather valve closes with the suction and water is sucked in through the steering knuckle.

Also, what is the purpose of that 13 mm plug? I don't believe oil goes in there, I think only grease goes in that chamber, but grease is generally applied via grease fittings. The manual says nothing about that plug. The only reference I saw regarding lubing the steering knuckle was where it told to pack lithium molebdinum disulphide grease around the parts during reassembly. Are disassembly and reassembly the only times they recommend lubing the steering knuckle?

That plug is for you to squirt grease into the steering knuckle. They don't put a grease nipple on it because it may be confused for a normal grease point. In ignorance, you will squirt the wrong grease in there and also over grease. It's not designed to take the pressure of a grease gun.

The hole is just big enough to get a grease tip in and will be pushed up and out if you fill the knuckle up completely. Whilst there is no specification on the amount of grease, it is generally accepted that 3/4 full of molebdinum disulphide grease will do the job.

Adding grease is part of the regular service. Grease does escape from the fabric seal on the back of the knuckle and the it needs to be topped up.