I’ve just set a test project up, pretty much as you describe in version 3, by creating a new workspace and dragging the two Xcode project into it, nested as shown.
You can delete the sibling project if you have it already.
Hitting build on this and it just works, as far as I can see.
I imagine there is internal path-confusion if you have two projects, and I’d be inclined to fiddle with location settings in “View”->”Utilities”->”File Inspector” and see what effect that has.
Another thing to try is to set your paths up in Xcode “Preferences…”->”Source Trees” and refer to them that way, as described here: Easy, Modular Code Sharing Across iPhone Apps: Static Libraries and Cross-Project References
HTH. Andy W.