I don't recall hearing about a string of differential failures on the X3. I did a quick search, and found two examples. One was in South Africa, and BMW covered it after a review of the service records showed that it had been recently worked on. Another was suspected differential failure, but turned out to be a wheel bearing. There have been some transmission issues (jerking, etc), and a few transfer case failures that have been blamed on different tire diameters, rightly or wrongly.

The dealer should explain to you exactly what is wrong with the differential. Assembly error maybe? I wouldn't call it a lemon, but I would want them to explain what had happened to satisfy me that it wasn't going to happen again.

The dealer may help you out with a discount on a new vehicle, but I wouldn't expect anything like you simply paying the increase up to an X5. Your vehicle depreciated as soon as you drove it off the lot, and it is a discontinued model that was being cleared out at significant discounts as the new X3 is out now. You will likely be offered wholesale used trade value for it. I'd keep it, as it would likely be a painfully expensive trade.

Good luck.

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2007 X3 3.0si, 6 MT, Premium, White

Retired:
2008 535i, 6 MT, M Sport, Premium, Space Grey
2003 X5 3.0 Steptronic, Premium, Titanium Silver
2002 325xi 5 MT, Steel Grey
2004 Z4 3.0 Premium, Sport, SMG, Maldives Blue