Honestly I think the “what happened “ is that Josh had an epiphany when Sheridan challenged him. When was the last time a younger race talked back that way? Not to mention all the time spent mentoring Sheridan, where it wasn’t some random that it could just be written off.
Remember that he still arranged for Lyta to get to their home world so she could be worked over.
Vorlons bio-engineered the younger races to perceive them as gods so they'd be more easily manipulated later. I don't think they'd have hesitated to completely reconstruct Sebastian's personality- if Sebastian even was Jack the Ripper. Or, ah, the original... jack the ripper.
we know that the Vorlons had an interest in human development (because they were creating telepaths as weapons.) It's possible they created Sebastian as an artificial construction, and the memories of being taken in was just to explain where he came from rather than "yeah... you were grown in a vat, bub."
Kosh Naranek aside... the Vorlons were assholes.