The reason he was instanced with the OP and the OP could not see him is the blocking mechanic, if the friend was also on the blocked list then they both would not see him and both would probably NOT be in the same instance as that player...
That is my understanding of the blocking mechanic and blocking people is there to allow us to 'reduce' the chances of being instanced with a player who we block but it was clearly stated in a previous thread back in beta that it won't be guaranteed to completely work if a blocked player is friends with an unblocked player in the instance... or if the blocked player is friends with someone else on your friends list and is in the same instance with that friend...
Which is an obviously badly thought out mechanic (again) by FD. So now we have an instance where different people see different things which kills immersion. We also have a mechanic let lets players just block out people they want - imagine this in BF or COD!! (neither of which I play anymore).
And of course this could NEVER be exploited, could it in say, clan wars "Block every player except Y...*kills him/her*...."Ok now unblock player X". Even if it doesn't work like this, you could block players to the point where it's 2 on one say.
Even if it's not exploitable, it's still beyond anything.