You really need to check with a good real estate attorney, however, my understanding is, until the day the bank actually forecloses you are still the owner of the home. I had a small house fire some time back, I was not in a short sale situation so I am not sure how that will effect you, but I know in my case the insurance company paid the contractors directly to do the repairs to the house and then paid me for the contents. I doubt that the bank would have legal standing to take any of the money to pay delinquent mortgage payments. The purpose of the insurance is to make sure the bank's asset, your home, does not lose its value. That will be accomplished when the repairs are done.
Definitely talk to an attorney. Let the insurance company do the repairs as they would under a normal situation, find a good realtor experienced with short sales and put the home on the market.