Sorry, I meant to reply to this yesterday but didn't get time. I was going to say that you could work out which sensor was dodgy by putting 5v and ground into the mouse and looking at the signals coming out of the sensors, but it looks like you've already worked out which sensor is dodgy.
Yes, this is definitely progress.
It sounds a bit like it's gone open circuit to me? How much voltage is dropped across the resistor will depend on how much current is flowing (Ohm's Law). If very little current is flowing then the change in voltage across the resistor will be very low. If the circuit is open, the only current flowing through the resistor will be through your multimeter, which will be a minuscule amount, and so there will be no noticeable voltage drop.
So—a good first step might be to resolder that component to see if it's just a joint that's gone bad, and check that there's actually a circuit between +5v and GND involving that LED. Failing that, you might be looking at replacing the LED.
A/UX will run perfectly happily off a “virtual” scsi2sd disc. That is how my installation is set up: multiple virtual devices for a recovery disc, two MacOS versions and A/UX. Never tried it on a IIfx, mind, but it ought to work.