Really does sound like the jaws are positioned or incorrectly put in.
When you close the jaws with the key, do the inner most 3 jaws meet or do only 2 jaws meet?
We took the chuck right off and just turned the lathe on without a chuck and he DTI'd the spindle that the chuck screws onto. The needle was moving up and down. Ive had a better look at it and i think it could be the bearings in this pic below? you can feel a tiny bit of play in them when the spindle is 'wiggled'
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