There were sponge blocks surrounding the gleam blocks but when lava is placed you can see which ones were “burned” away. Is that suppose to happen or is this a bug?
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Liquid is populating whole block. But shows only on chiseled part so it burns sponge, wood… etc stuff that it touches.
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Lava burns things
Use only metals, gleam or stone blocks around it
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and it only burns the full side adjacent blocks, not diagonally connected via corners
and as @almund said, it doesn’t have to fill entire block; if due to chiseling it visibly occupies only chunk of space of a block, it still gives this block properties of a full block of lava, meaning burning adjacent flammable blocks (wood, foliage, sponge etc.)
I guess that makes sense but to a simpleton like me it seems like the lava shouldn’t burn the sponge because it doesn’t look like it is touching it.
From what I remember light and fluid use the same mechanics within the game. Because lights were around way before placeable fluids many people used the technique to create hidden lighting effects. When fluids were finally introduced the “leaking” of the light through chiseled blocks was going to be fixed but so many people complained about all the work they had done lighting their builds using this technique that in the end it was left as is.
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I have been thinking it has something do with that how liquid flows. If you put liquid over single block it splits to four main direction.
GreyArt has also good theory 
A chiseled block with a liquid placed in it makes it a “liquid block”. In this case
One lava block if it flows down from it source its technically making a cross pattern.
Black source
Red flowing (down)
In the case of lava the flow blocks are the blocks that burn plus the blocks under neath “flow”.
In your shot you have a square of 2x2 blocks and one source block in the chisel part. (Game sees this as a flat surface).
If you place lava normally on a flat block surface it flows out. It is 3,5 blocks so say 4 from source creating this pattern from top view.
Because the chiseled area is
Is viewed as a flat surface the lava flows “off the edges” in a way of speaking.
In this case orange is the flowing lava (in the chiseled area) contained. Yes but the “drop flow” can only be stopped with a full block next and underneath it (this bock may be chiseled but has to be in a way that it blocks the flow). This has to be a non burnable block like stone, metal, glass… organic blocks will burn in the red area.
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Hope this helps 
as i use it a lot im my build and have to figure out ways to make it work.
Keep in mind liquid mixing/chisel combining has an other set of rules.
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Best way to see how far you can take this is by placing a source and see what you can chisel before it leaks.
Green block that keeps the liquid in place.
Black just one source block.
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A block is split into 8 parts take off one corner and you break the liquid block on the 3 faces touched by that corner, take of one edge and you affect 4 faces that touch that edge. You need a intact block face unaffected by chiseling to block liquid flowing through it. Use water and glass to play around and you’ll get the idea safely. Source in the top middle
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Here’s another explanation from lucadeltodecso
[/quote]
quote=“lucadeltodecso, post:2, topic:35507”]
we have to store a single piece of liquid data for a given block space, so we cant have a liquid exist in one half of a block, but not the other half etc. In this case, it means the liquid has to be able to flow through the block entirely.
[/quote]
Edit: always seem to have trouble placing quotes when I post from my phone.
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its’ the heat 