I understand the legality, and lack-there-of, but my only problem is that it was probably going to be really good. In this case, couldn't Square, oh, I don't know, give them, instead of a "cease and desist," a, "Come into talks with us?" kinda thing? What I mean is, they could look at the game, and, if it really is quite as awesome as it sounds like it was going to be, basically say "Alright. You guys walked a fine line, but we really like the game. Finish it up, send it to us, we'll add the polish, and then we'll release it on the DS, XBLA, and PSN."
Seriously, that could have made everyone happy. We would have gotten the game, the people who made it would have gotton it released, and Square would have made money, at little to no cost to themselves. And the people who made it would have to accept whatever bare-bones paycheck they might get from Square as a thank you. Then, they should be hired, assuming they don't have jobs in the industry already.