I also raise the questions on how or why the bank allowed you to continue making payments and under what terms? There are many things that need to be answerred and unfortunately can not be resolved on a blog. Again, I am a licensed REALTOR and the answer you seek goes beyond my legal parameters. Please contact an attorney that specializes in real estate law to resolve the issue.
Most contracts (especially TAR - Tennessee Association of Realtor's standard contract) state that seller must furnish clear title to convey the property. The evidence of a lien is found when your closing agent performs an abstract title search - which they did and supposedly remedied the situation. Then the buyer's closing agent issued title insurance (or did they?). Did the buyer's title company issue a policy for the lender & the buyer's (called an owner's policy)? Every title policy is suppose to go through a review (called an opinion), but in the hayday of the real estate boom - many closing companies hired bodies to perform their closings, while the attorneys were enjoying great leverage. Some horrible mistakes were made!
The fact that the bank allowed you to continue making payments on an instrument secured by your primary residence after that property changed ownership shows that someone came up with the "executive decision". Now the bank is saying that this is just not so and they want their money. If the title company pays if off, then it was their fault - that's why it's called insurance.
This is a legal matter and since I do not have a license to practice law.......you need to consult the attorney that closed you. If you went the conservative path and there is no attorney on the closing companies staff, then get a consultation with an attorney that handles real estate matters to find out first hand what is the liability here.
Don't delay and best of luck to you.
In Arizona we use title companies as part of the real estate transaction and transfer of equitable title process to clear any existing liens or encumbrances, I'm not familiar with your stale laws and practices of course, but if you used a title company to do the "Step Down" title search then your title was insured against this type of problem. In this case, I would contact the title company.
If you used an attorney to close and handle the paperwork, call the attorney immediately.
Best of Luck,