After you useD EAD, you gave up H1B. Accordingly, H4 became invalid because it is based on H1B status. So your wife has been out of status since 03/2006. Although your wife filed I-485 in 09/2006, she may not be in AOS status because she didn't have valid status at that time, and CIS may consider the time since 03/2006 to be illegal stay.
Find a way to solve that problem. You should take action early after her change of status was denied in 08/2006. May God bless you!