Update: so EW did send a replacement o-ring which arrived a few days ago. Happy with that service. You can clearly see now that the old ring has expanded dramatically. The new ring fits inside the old one without an issue. New ring fits the hub just fine. So did another service and put everything together.
Issue: the freehub is now dragging again. Pedals keep spinning while freewheeling - again. To double check this is definitely the o-rings fault and not the grease or anything else, I removed the o-ring again without changing anything else: freehub now works as intended. No additional drag or pedals spinning with it.
My suspicion is that, for whatever reason, the o-ring increases the drag on the freehub considerably. I also suspect this is what made the old ring expand so dramatically. O-ring increases drag ==> increased friction while freewheeling ==> increased heat ==> o-ring rubber expands beyond recovery.
Does anyone on this forum have the same wheelset and have similar issues with their hubs and o-ring? I am pretty sure I put the o-ring in correctly (not much options anyway) but could not find any manual regarding this wheelset that would confirm it.