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Teddy/Andrew is getting injected with a heavy dose of Scarecrow's formula
That would describe the whole movie.
Teddy is aware that he is going to get lobotomised and actually wants it.
Hence his "Isn't it better to die a good man than live as a monster?" (paraphrased) line. He didn't regress. He's just pretending he did, so he doesn't have to deal with the Awful Truth.
- I thought that was clearly implied by the film with that last line, so not so much a WMG as Canon.
The movie is a prequel to Inception.
Shutter Island's psychiatrical research succeeds in creating a device that can enter dreams. Teddy reinvents himself as a dream agent and escapes with a copy of the device.
- Except in Inception, his wife and children are alive. Or he thinks they are. But that means... whoa, wait...
- The wife definitely isn't alive in Inception, but she sure is crazy.
Inception taken less as reality than the above idea. The lobotomy goes successfully, and he gets what he wanted: his guilt is subverted to an extent, his wife (the monster) is gone and mostly the guilty one, oh yea and his children are alive. This is what he wanted in shutter island, to destroy his wife which he viewed as a monster, undo the death of his children, but he also needed to face his guilt for killing his wife.
Teddy's "fantasies" are actually true.
After all of the trauma he's been through up to the reveal, it was easy to convince him otherwise.
- With this in mind the movie could also be seen as a meta Cassandra Truth. The woman in the cave states that once a person is declared insane, no one believes them anymore. Once Dr. Cawley declares that Teddy is insane, most of the viewers accept this.
- If the island really is doing brain experimentation -- including "removing memories" as Dr. Solando suggests -- then it's only a relatively short leap to believe that they can also implant memories -- such as "no, Daniel, you killed your wife." Etc. And now that they've managed to succeed at this, albeit temporarily, twice, they are lobotomizing him to destroy the evidence.