Axle spacer turning

Bike is a 81 KZ55A2. Kid burned up the bearing on sprocket side. Nut was so tight the wheel almost wouldnt turn. Today i got new bearings and put them in. However when I tightened down the nut same thing happens. So i loosened the nut till the wheel would turn freely and started the bike. I noticed the spacer on the sprocket side that goes into the dust seal will turn on the axle and its not supposed to. Looking at the parts fiche I noticed theres an oring, part number 671B255 on the sprocket side. I didnt see any oring when i took off the wheel and pulled the axle. I laid everything out in order for reassembly and no oring.
So my questions are where exactly is this oring and does it fit next to the bearing?? And second is why is the spacer turning and why when i tighten the nut does it seize the wheel? 
Only thing im unsure of is the spacer that fits inside the sprocket hub. Somethings definitely missing on the rear axle set up. Guess ill take it off the swing arm in the morning to check that everything i see on the fiche is there.

Your wheel shouldn't bind but..if someone previously over tightened the assembly then you distort the hub spacer between the bearings. This makes the radial bearings ride on their sides, tightly. Sprocket carrier bearing shouldn't be affected. Might have to find an NOS hub bearing spacer or distance it slightly, like 004", very slightly. 

When you fitted the new bearings did you seat them gently on the centre spacer (too much they will bind straight away, not enough they will bind when tightening the axle nut)