You can interpret the movie a million different ways.
My interpretation is based off of the small behaviors many characters have throughout the movie. Like the guards; who in the begging of every scene involved, watch Teddy with fear until Teddy faces their direction, then they look away. The guards, the policemen and his “partner” does this constantly, in situations that do not make sense. The argument can be made that Teddy is a crazy patient and they were fearful of his violence..yet other events don’t add up with that perception.
For example, in one scene Teddy climbs down the cliff to get to the lighthouse. There was a cigarette he picked up, and a body at the shoreline which really wasn't there. The lighthouse was supposedly where Nazis did surgeries on the human brain, manipulating their thoughts and emotions..weird how in this scene, when Teddy reaches the bottom of the cliff rats come out- from what looks like man made tunnels in the rocks. The rats conveniently surround the only way to the lighthouse. This redirects Teddy to the cave with the doctor/escaped inmate.
The feeling I got from this scene was that Teddy is like a rat in a maze, constantly being redirected. I think that Teddy is perfectly sane. And that he was being redirected to the cave because someone didn't want him to see a truth they could not cover without killing him.
My explanation for Teddy’s hallucinations is this:
Nazi’s found a way to dig inside his brain before Teddy made it to Shutter Island. Somehow made it so they can make him see whatever they wanted him to see at any time, regardless of where it is. It could be physical technology, occult channeling, hypnotism who knows. If Teddy was totally nuts in the movie, that would mean he spent two years in Shutter Island.
But then how would he obtain a marshal badge or arrive on a ferry? Why would a crazy lady see Teddy and put her finger to her lips, as if to stay silent? Why would another woman write for Teddy to run while his “partner” was getting a glass of water? Why would a police officer casually speak of mind experimentation, mysticism and occultism for no reason at all? Why would a German doctor speak of pushing a good man to commit violence if he wants ideal social sanity? Why?
Because, if you really are aware, you must swear not to speak of these things. You take a vow of silence, or a vow of exposing deceit and I like my choices. It’s better to die a good man. Your crazy to think Teddy is crazy.