Exhaust in diesel engine's raw-water circuit?

[wmauldin]

So the symptom is exhaust--or some other gas--finding its way into the raw-water circuit of my Universal 5411 diesel engine. What's the disease?
The mystery occurred as I was working last weekend to troubleshoot a lack of cooling water circulating through the engine following a freeze. While messing with each and every hose in the water circuit (the engine is cooled with sea water and doesn't have a heat exchange), I noticed the problem.
Specifically, I took off the old hose (bypass hose?) that moves water from the main engine block/cylinder head to the exhaust manifold. When I started the engine, I was surprised to see that not only was there no water, but there was also exhaust or perhaps "blow-by" coming out of the engine side. Putting a thumb over the opening I was able to block it for a bit but a fair amount of pressure built up.
Later I fiddled with the raw-water circuit again and got water and (and subsequently antifreeze) circulating happily through the engine and exhaust manifold again. (I verified this by initially using a clear PVC tubing and could see the liquid coming through that short pipe.)
But the gas going into the water system worried me. I am also getting a fair amount of gas coming out the crankcase ventilation pipe on the top of the engine. Any thoughts on what, if anything, is wrong with the engine?