mul-ing the normals by the world matrix is going to not only transform the orientation, but also the position, which you don't want- this is causing the overreaction. Maybe it's just me... but I think you want the untransformed normals just raw, maybe normalized...

EDIT: ok.. I see what you mean, reading through again..
You should probably set up your own matrix that doesn't have the translation multiplied in. Or you could mulitply the world transform matrix by an inverse translation for the objects world position...

-Rhuarc