xhonzi said:
I want to say that the director commentary addresses the "ambiguity" of the piece.
If not, then I guess you both are just wrong. :)
In other words, watch it again and try to see it as "all a lie" to convince him. I think you'll find that it plays that way to the degree that there is no really conclusive evidence against it.
But you can go debate it on the imdb forums too, if you'd like. http://www.imdb.com/title/tt1130884/board/
After watching it and paying close attention, there are so many moments in the movie that you think are working towards the "all a lie" outcome, only they work much, much more towards the "he's crazy" outcome once you realize what's going on.
For example, when Dr. Cawley (Kingsley) first meets Teddy, he mentions that Rachel Solando's children drowned, and looks carefully at Teddy/Andrew just as he says the word "drowned". Watch the guards, and their behavior around Teddy, especially in the beginning. When Teddy sits in on the board meeting the members are clearly annoyed that a patient has been allowed in, and one of them even jokes about how clever the rule of four is, only to get an angry glance from Dr. Crawly. Also, when the warden and Teddy are in the car alone, the warden mentions that Dr. Crawly thinks he (Andrew) can be cured but he does not. They have that long talk about "violence" and such, and it really doesn't make sense in the "all a lie" viewpoint. There are other, very obvious clues, just watch it again.
One HUGE clue is the theme of fire and water. Fire represents Andrew's insanity - the matches in Ward C, Rachel's fire in the cave, blowing up a car, etc. - while water represents the reality that he's trying to hide from - his wife drowning his children in it and all. A big clue that Rachel Solando was completely a figment of his imagination.