I think both you and your husband are right. Laurie is in the asylum physically, but it looked to me as if there was some morphing used to make her face a combination of her own and young Michael's. Basically the same kind of thing Hitchcock did in 'Psycho' where he superimposed Mrs. Bates' face over Norman's.
We're supposed to conclude that Laurie has gone so far off the deep end after her ordeal that she believes Michael's psyche has joined with hers. Or perhaps we're supposed to believe this has literally happened through some supernatural means. The movie seemed unclear on this issue to me.