Hello,
If you block the return duct, the system will not work properly. Trying to remove a sponge to allow the system to work is WRONG. Insulate the outside of the duct. Maybe use spray foam to coat the duct.

It would appear that somehow your fireplace insert is tied in with you regular heating system. You will have to go do a little crawling around and tracing of the duct work and block it off where it needs to be. You have to be careful though to make sure it doesn't affect the rest of your system. If you're not comfortable doing it or not sure you're probably better off hiring someone who will understand what they're looking at in your house. It's pretty difficult to see into your basement from here.

I'll add a guess.

The fireplace is drawing air out of the house. The cold air returns aren't ducted inside the stud cavity but simply attached at the bottom. The house was buit in 1937 and isn't sealed that great. The make up air is being pulled through the wall from outside and then through the vents into the house.

Are the returns in sealed duct, or just in the cavity?

Sorry fellas for not getting back to you. I must not have turned on the email notification for this post and forgot that I posted it.

My cold air returns are just cavities between the wall studs until the basement.

My fireplace insert is not tied to furnace heating system.

I believe that the fireplace insert is pulling the air from the ducts into these rooms.

Thanks for responding before...

Andrew