Steep in the smaller volume of water. Once you're done steeping, you can pour 170 degree water over the grains, up to your boil volume.
The reason for this has to do with pH. Steeping with more water raising the pH, usually above the desired pH for steeping or mashing grains. Also, more time isn't better. As an example, think of a tea bag. Steep for 3-5 minutes, and you get great tea. Steep for half an hour, and you've got a harsh astringent flavored liquid.
The same is true of grains. You're after the color and flavor (like making tea). That's it. Once you extract the color and flavor, all you've got left to extract is tannins and a grainy taste.