I believe the answer is number 1. It definitely always starts the timer over again for the stack when I’m using it so I would bet it’s just discarding and applying a new stack when it procs.
I was low key hoping it would be 3. Sometimes people are using several skills with different damage. It would be nice if the spreading flames stack with higher damage will be applied in this case.
It’s possible I’m wrong since auras take the stronger effect, but I’m pretty sure ailments are calculated on application so since spreading flames is limited to 1 stack at a time it most likely just replaces it.