I've not used the system so I don't know much about it. My guess would be the dry mouth thing would be your problem. Assuming it's a good regulator and in good working order, there is no easy way for water to get inside (that I can think of, without a malfunction, such as the exaust valve folded over, or dirty) but you've got a device inline to introduce moisture.
My thoughts, not knowing the system, would be, too much water in the "sponge" after which as the pressure increased it just pushed the water right out of the sponge. I would go do another dive with it, with the sponge dry, or removed completely.
It's not uncommon for a low performance "octo" to perform badly, esspecially those low profile things which are SO popular (if I had my way, I'd throw them all away and drowned the guy who invented it) They perform like crap on the surface, and even worse in even 10' of water... I'd hate to test one in more than 30' of water, as it probably can't deliver the air a stressed diver needs. If it's not a low profile but still low performance, you still have the same issue. I use an R380 as a backup and it is very comparable performance wise to my primary.
Like I said, I would redive it with the sponge dry and or removed completely. And if you have an icky "octo" you may want to consider a nicer one? I would also just get someone like the dive shop to look over and test the reg out prior to the next dive, that way you KNOW theres nothing physically wrong with it... they may also confirm that you had too much moisture in the sponge, OR that there was some sort of failure which they can then resolve.
Just my 2cents....