They aren't prohibiting "Free Software", they are prohibiting software that is under a license that requires the distributor to pass certain rights along to the recipient. Hence GPL like licenses that require distribution of source code, and that you grant redistribution rights to everyone you distribute it to are being explicitly prohibited. (And in fairness I can see why those licenses would cause problems for Microsoft as distributors) On the other hand BSD like licenses that allow you to repackage and distribute without source and without passing rights forward are acceptable.
On the open source topic see another discussion here http://news.ycombinator.com/item?id=2226260 and this quote by SimonPStevens
As an aside for those interested in how easy it is to setup or how much you can customize it. I setup this site for my last job at http://www.gwca.org/ (its been a bit butchered since then so your mileage may vary) and it had a steep learning curve but was extremely powerful and very easy to customize.