Thom's writeup is pretty good. Herein, more information to add confusion to this mess.
It seems likely that what caused Google to attack with lawyers was CyanogenMod experimental builds including the unreleased new Market application (which app is nice, btw). C has been pulling features from experimental SVN branches for months, but the binary Market app (closed source!) was leaked/released by mistake/your story here.
ROM cooking and distribution has always been legally grey but Microsoft, HTC, Motorola and other major companies have rarely C&D a non-commercial distributor. The forum where most of the activity took place has lots of people redistributing ROMs with copyrighted pieces in them. Hardly ever has a manufacturer complained.
The opensource parts of android (the AOSP code) don't make up a functioning phone ROM. Google engineers are working on some of the most egregious aspects of this.
There are devices in various countries on the market that run Android but are not Google Experience licensed. This is probably Google's major concern about these apps along with them honouring agreements they have with other companies (HTC, map data providers, etc).
Market is not available except with Google Experience licensed devices, so the other apps "free beer" status as free downloads is not as important. Other software distribution methods work fine without the Market, but no one really want to have three, much less six or more such apps/markets.
That last bit is what confuses me the most. I can't imagine Google actually wants to force a fork in the fledgling Market space.