I think the argument for killing these sort of projects in order to protect your IP has long been dis-proven.
Valve is the most potent example, their engine is used for mods, their own IP is used to make high quality videos, and much more. They don't only allow this, but embrace it and foster it. And it has made them one of the most important and successful gaming companies out there.
How about the Mega Man "Mega Ran" remix? That was embraced and both parties benefited.
Should Square allow people to use their IP willy-nilly? No. But they could embrace it, and control it to some extent. Foster a community around their IP.
A response as drastic as this is just bad PR over an issue that was in no way going to deprive them of sales nor allow others to profit from their IP and tech.
Bad move Square, get with the times.