what IR LED I dont think it has a IR LED???
Sometimes the IR LED wavelength is outside the camera's frequency range, so the camera test isn't always perfect.
The LEDs are in the opto circuits. (the two black c-shaped items at the bottom of this pic)

Each opto circuit contains an LED (left side) and a photodiode (right side) in the c-shaped enclosure.

The encoder wheel either blocks the light (logic low) or allows it to hit the photodiode. (logic high) More details
here.
The two opto circuits generate voltages like this as the encoder teeth block both optos (1), then only one (2), then neither (3), then the other.(4)

BTW, I
really wasn't kidding earlier when I posted that you should get a terminal strip for these connections -- GGG and Radio Shack both carry the
euro-style ones.
To troubleshoot your spinner step-by-step:
1. Disconnect all four USB wires from the spinner connector wires.
2. Ensure the bare ends aren't shorting together (preferably using the terminal strip) and plug in the USB cable.
3. Use your multimeter to confirm that the black USB wire is indeed ground. (0v relative to the USB connector's metal outer shell)
4. Confirm that the red USB wire is 5v relative to the black wire.
5. Unplug the USB cable.
6. Connect USB black wire to spinner blue wire.
7. Connect USB red wire to spinner brown wire.
8. Connect the spinner connector and plug in the USB cable.
9. Confirm that you now have 5v at pin 11 of the IC.

10. Check pin 1 for a logic high (close to 5v) -- if it reads logic low (close to 0v), turn the spinner knob slightly.
If the pin does not give a logic high, the related opto circuit is probably burned out.
11. Repeat step 10 checking pin 2.
12. Unplug the USB cable.
13. Connect the two USB (blue and white) and spinner (green and orange) data wires. Not sure if blue goes to green or orange.

14. Plug in the USB cable.
15. If the spinner doesn't work, swap the green and orange wires and try again.
16. If that doesn't work, reseat the IC and repeat steps 14 and 15.
17. If reseating the IC doesn't help, you may need to replace it.
Scott
EDIT: Here are several parts links for the
SlikStik Tornado Spinner.
Opto (DUAL CHANNEL SLOTTED OPTICAL SWITCH) -
http://na.suzohapp.com/all_catalogs/accessories/S822-SD?SS=BOMReplacement PCB (USB PS2 SPINNER PCB ASSEMBLY WITH AXIS SELECTOR SWITCH) -
http://na.suzohapp.com/all_catalogs/accessories/95-2780-00Pre-fab mouse button cable (3-Button Cable for Tornado Spinner) -
http://na.suzohapp.com/all_catalogs/trackballs/55-0305-00