Electrical – Regarding pinout of PCF8574 I2C 8-bit expander

Okay, I can see the changes.

As shown now, the LEDs on the receiving IC will block the data high as they are reversed. The LEDs on the transmitting side aren't a good idea either. If you want LEDs you need to put them from the data line to ground through a resistor, not in series with the connection to cable socket.

Just seen your picture - it looks like you have removed the LEDs, good (I was just about to suggest this.. :-) )
So now it looks as if you have direct connections from IC1 to IC2. If this is the case then if the code (looks reasonable at a glance) and IC wiring are correct then it should work.

If you can confirm with a multimeter that the input pins are seeing a high (or low) voltage and the read value is different, then this would confirm the issue is one or the other of the above. Maybe just apply a known voltage directly and see if you can read that okay)

However, if you are reading different values when the pullups are on/off then that would seem to indicate the read is correct. Try reading a direct voltage and post results, I'm just checking the datasheet for the ICs, will add more shortly.

EDIT - about the pullups:

You can use the internal pullups if you don't mind the line "relaxing" to high when not driven (i.e. default state 1) These are often used for interfacing with open drain buses, or for button to ground, etc to save an external pullup.
If you want to have the lines default state low though, (as is the case for you) you need a pulldown to stop the high impedance floating. Since the IC in question doesn't have internal pulldowns, you need to add them externally.

EDIT - Doh! I've just seen the problem...

In your code you set 1 pin at a time to output and all the rest to inputs. This means that if you have internal pullups on, the undriven pins will default to high! When a pin is set to input, it is high impedance, so effectively it's like disconnecting that end of the line, and the weak pullups will pull the receiving end high.
You need to keep all pins as outputs, and just set one high at a time, this will keep all the pins driven - try this with the pullups on, it should work.
If you know the lines will be driven correctly all the time, you don't need the pullups, but it doesn't hurt to keep them on.

Here is the relevant code (in the intialise registers function):

i2c_start_wait(SLAVE_ADDRESS(0x4E)+I2C_WRITE); // Address Slave 1
    i2c_write(0x00);        // Set memory pointer to the IODIRA register (IODIRA address is 0x00 - see Page 9)
    i2c_write(~(Value));    // Set only one pin at a time as an output and everything else as inputs
    i2c_stop(); 

Change it to:

i2c_start_wait(SLAVE_ADDRESS(0x4E)+I2C_WRITE); // Address Slave 1
    i2c_write(0x00);        // Set memory pointer to the IODIRA register (IODIRA address is 0x00 - see Page 9)
    i2c_write(0x00);    // Set all pins as outputs
    i2c_stop();

I've recently rolled my own as far as I2C connectors go. The connector itself is not very important, right now I'm just using 100mil pitch header (usually female on board so it's not so pokey when not connected), but any 4plus pin connector will do. Additionally, I'm using the P82B715 from TI as an I2C bus extender. This overcomes the capacitance issues associated with running long I2C drops off board, which as people have been saying, I2C was not intended for initially. I did try many different combinations, like in the examples you gave and I noticed absolutely no difference in performance. I believe this is because I2C is relatively slow, interference between SDA and SCL is not much of an issue. Basically the rise time for voltages (when interference will occur) on the bus are much much smaller than a bit length. So, that may not be what you want to hear, but it does afford more options. Personally I went with [VCC, SDA, GND, SCL] to be easily routed to/from this chip and also be immune to a VCC/GND mix up when plugged in backward.