My DCs are older now, but when they were younger they knew that some people liked to look/touch your intimate parts and that it was very wrong, they should not allow it and go straight to parent/teacher if it happened.
In Y3, at roughly 8, they would have been disgusted by it, but not upset, unless it had happened to them as well. Or had done it themselves and feared being in trouble.
I am not minimising what happened, but a child sobbing and upset about it when not involved is a bit odd.
The only reason I can think of to be so distressed about it would be being raised believing everything involving intimate part is revolting and sinful and now the child thinks something terrible is going to happen to the two involved.
I knew a family like that. Hiding the body, school uniform two sizes too big, only books allowed for in-class reading were Christian books, the mother greeting everyone at the gates with " have you felt the love of jesus today?" . Not saying this is your case OP, but your child reaction is not typical. Most at that age, would believe it is gross, not sob in a way they never did before.
I believe the school was right to talk about it