I setup a second context and have everything working. However, when using Friendly URLs all pages except the index of the subdomain get redirected to the 404 of the original domain. The original domain works as expected. The HTTP headers are passing a 302 error. Any ideas?
What routing method are you using? If I recall you need to change the context dynamically using a routing plugin linked to page calls.
It sounds like you're looking for pages in the wrong context.
Ah I see that this method involves editing the index page. I don't touch the core, I always use extending; hence using a plugin.
I don't think I ever got multi context 404s to work personally, so that may be a red herring. If I recall it always hit the 'web' 404 page, despite overriding the context specific setting.
You may want to share your .htaccess file here, because it sounds like that may well be the issue. Maybe you didn't remove the furl directive for the original domain from the .htaccess in the sub dir?
Personally I mostly use nginx, so I may not be able to help, but someone else could spot the issue.