I also agree that sticking with your obligations is the "ethical" thing to do but sometimes we bite off more than we can chew and we have to face facts and lie in the beds that we make. I do not look at the OPs situation any more differently than someone who had their debts pile up and then has to file for bankruptcy. It just is what it is.
With that said, is bankruptcy an option? If you're considering a foreclosure anyways then I think bankruptcy is a better option to get rid of any other debts you may have ... if you're gonna ruin your credit with a foreclosure, a bankruptcy may be a better option and also cover you for any deficiencies or other nasty issues that can pop up when you stop paying your bills.
I would recommend talking to a bankruptcy attorney... they usually give free consultations. Even if bankruptcy turns out to not be the best option they could give you a more "legal" view point as to what you should do. Perhaps foreclosure is your best option, but that isn't really for us to tell you. Also, a lot of times the banks are not willing to work with you if you are current on your mortgage. Why bother helping someone in financial trouble when they are paying their mortgage on time right? Usually, they will be more inclined to work with you if you are already behind. This could also be why they denied your short sale request. If you get behind (ie stop paying) and they realize they are going to lose the house anyways, they may in fact let you try to short sale it or even give you a loan modification.
I would of course do as much research as you can and do one or more consultations with bankruptcy attorneys. Also look into rentals and see if you would be able to find something to rent that is in your price range and in a desired location.
