I agree that options 2 and 3 are correct if they still pray every day and that only option 3 is correct if they no longer pray every day.
But the question as given is select the one which best expresses the same sentence.
I hate questions like this because they provide incomplete information.
I personally believe that if they still pray every day that option 2 is more commonly used and, therefore, the best answer. (But I have no empirical evidence to prove that; it's only my subjective feeling. I can't state it to be the best answer from a grammatical perspective, only from a personal style perspective. However, style in cases like this is personal. While you can't prove yourself right, neither can somebody else prove you wrong.)
Consider this dialog:
"Did you ask them if they pray every day?"
"What did they say?"
"They said that they do." OR "They said that they did."
In normal conversation, the first response is far more likely—as, I believe, is its option 2 equivalent.
If you want to choose an option that best satisfies all possibilities then option 3 is the best option.
If you assume that best is being used deliberately (as opposed to only) so as to indicate a choice, then that means that more than one option is actually correct. Therefore, they must still be praying—so refer back to my first item.
If I were forced to pick an option without any more information, I would pick option 3. (While I don't necessarily find it the best, I find it the least wrong among all possible scenarios.)
But I personally agree with your answer. Assuming that the praying is habitual and that it has not stopped, there are two correct answers and, stylistically, I believe yours is the better of the two. However, the instructor might not agree with this assumption. All you can do is try to offer such an explanation. It will at least demonstrate that, if you failed, it wasn't because of a lack of knowledge on your part but because of an incompletely worded test question.
(Unfortunately, I've rarely managed to convince past instructors of mine to correct a mark by pointing out things like this. I wouldn't rest your hopes on changing the mark—but it's still good to at least try.)
As a final note, I took a grammar course last year. As part of the course material, it mentioned reported speech versus direct speech. I knew, ahead of a test, that "backshifting" was expected. So, on the test, I made sure to follow that. But that expectation had already been set—and the examples I was given didn't present two possible answers.