It was probably standard drywall and, over the years, the water seeped in and destroyed it. It's actually good you found it as the mold could have become an issue. Remove all wall material that is at all compromised, and trim to a clean, straight edge. Give the studs adequate time to dry out before you continue the repair, and consider spraying anything that looks iffy with mold-killer. Then, mount waterproof backing board, shimmed out if necessary, and grout to form a continuous surface with the remaining wall. If the existing tile is clean and flat on the back, you can reuse it. If it were me, I'd be tempted to go with something new, install it with the proper tile adhesive, and go a little higher on the wall to cover the seam between the old and new wall surface.

So we might not have to tear out the entire thing? Just where the drywall has crumbled? Since it's a 3 sided shower enclosure, we're "assuming" the back way farthest from the shower head is ok.

The side wall would receive the most water spray but it did look like the head wall (that you can see from the access panel in the closet), is a little soft too. Is it safe to think that the plumbing itself is sort of "freestanding" so if we took out the tile and drywall around it, it would stay put?

I know nothing about plumbing, can you tell?

You only have to tear out where you want tile to go back. Not above the tile, or the ceiling. For that you can be thankful.
This is what they make cement board for. They never should have tiled over drywall, but none of us is perfect. The tile isn't really going to be reusable, as it has old mastic on the back; let me put it this way... is it worth your time to scrape all the mastic off all the tile, or just go buy some new stuff? 4x4's are very cheap in stock colors at the big box stores.
Casey

Right Casey, and it's 4x4 WHITE tile to boot, not a problem to replace that I'm sure. Since the entire bathroom is done in that tile.

Ok, so our contractor is stopping in tomorrow to look at the mess and give us advice.

NOT what I planned on doing this weekend. (or ever)

:)

There is an amazing product that will help you, without replacing the walls, this product is amazing it kills mold,virus,insects,rats,mice, anything you can think of, when this is done to your house all smells are gone as well, the product is call: Clean Zone Systems. Their web is www.cleanzonesystems.com

Let me know if you find it helpful

GOOD LUCK!!!

Um, no smells in my house so I think I'm good on the cleaning system, thanks.

Contractor came yesterday, said "yea, you can do that yourself, no problem!" So now we have to get it into our schedule, maybe next weekend. In the meantime there is a lovely shower curtain liner duct taped to the back wall and the babies get their tub time downstairs in the clawfoot.

Good thing I put THAT thing in last summer or we'd really be SOL!!

Even 'greenboard' fails eventually by moisture penetration.
Walls that the shower can play on need cement board.
Do NOT omit a moisture barrier under the cement board. 15 pound tarpaper is enough, or even one of the newer membranes.
Cement board is 'waterproof' only in that IT is not damaged by moisture. Being a cement product it wicks moisture VERY well.
Tile can be waterproof AND stop wicking (the glaze layer on wall tile) BUT the grout does wick moisture. This is what kills using plain drywall or greenboard for a backer.

Older houses leaked enough that the small amount of moisture through the grout and into the mud bed did not stick around long enough to cause problems.
The mud bed could also hold a lot of water before it really started to work through.
Newer tight houses and the relative thin cement board require a little more protection from wicking moisture.
A single layer of correctly lapped 15 pound tar paper does the job very well, and the stuff remains cheap.

Do yourself a favor and remove all of it. Anything else is a waste of time.
Ron

"Right Casey, and it's 4x4 WHITE tile to boot, not a problem to replace that I'm sure."

Not so fast! White is not white is not white - just about every manufacturer had a subtly different white because of the variations in proprietary bases and glazes, and white tiles' subtly changing color as they aged also isn't unknown. Not much looks worse than "tried to match and missed". You may have to schlep one of your tiles around a bit to several different tile stores (and don't just match them up in the store, bring a sample home to check out in your bathroom lighting) to get a perfect match so that the one area doesn't look different from the rest. Jane Powell has a great discussion of how to "stretch" reused old tile in Bungalow Bathrooms.

After estimating the cost of new tiles, plus the time it would take to get the old adhesive off the back of the old tiles, we decided to just go with the same 4.25" x 4.25", with an accent strip around shoulder height of a nice soft powdery blue variegated tile.

We (husband) tore out all the backerboard/drywall/whatever it was that had crumbled, luckily higher up on the wall there wasn't any mold or as much damage behind the tiles. Of course, that made it more difficult to get them off the wall, hence the need to factor in time to get old adhesive removed from the backs.

New solid core durlock backerboard is up, now it's my turn to tile.

I'll post pictures later!