There is nothing wrong with your OBi. The behaviour you experienced is to be expected.
The PHONE1 socket of an OBi1202 is wired to support a 2-line phone. One phone circuit is on the centre two contacts (3 and 4). The other phone circuit on contacts 2 and 5. .
The PHONE2 jack has only its contacts 3 and 4 wired up. They are directly connected to the 2 and 5 contacts of PHONE1 jack
If you use a cable with 4 conductors between PHONE1 jack and the 2-line phone then both phone circuits of the Obi202 are connected to the 2-line phone. If you then connect an AT&T line to the phone you are also connecting it to the OBi's second phone circuit. Do not do that as not only does it cause the flashing LEDs etc, it can can permanent damage to the OBi. (And AT&T will not be pleased either!)
If you want the OBi PHONE1 jack on line1 of the phone and AT&T on line 2 of the phone be sure to use a cable with only 2 conductors.