DS is 4, friends DD, let's call her E is 5. They've known each other from birth and see each other regularly. We were over at E's house for play date and while we sat with our little ones DS and E were in her room, playing with the door open. My friend N casually popped her head in the door, gasped and told me to look. I was expecting to see some sort of construction or huge mess, instead DS was lying on the floor, pants and undies down to knees. He was playing with his penis, while E with her back to us also undies down to knees sort of leaning over him watching proceedings. They were both giggling enthusiastically, just having "fun". I don't think there was any touching each other.
N was shocked, i had not expected this and didn't know what to do so did the wrong thing by marching in, lifting DS from floor and pulled up his pants saying how this is not right, we're going home. Cue him wailing no, he wants to stay and play. I then picked him up and took him to another room. Sat him down and explained -calmly by then- that his willy is private and only for him to play with and look at. We have told him this before, it is fine to touch himself but he shouldn't show his parts or ask to see anyone else's.
We then sat them down together explaining same thing, privates are private ect. They nodded and went out to play another game quite unperturbed and happy.
The thing is, I know this was completely innocent and normal behaviour, but I don't really want it to happen again. It just seems wrong somehow, to see your child like this. We were talking with E's dad later, and he was very relaxed about it, even questioning whether we shouldn't just let them get on with it, rather these two exploring where we know the child and parents well than following their curiosity elsewhere ie at school 
or so.
Sorry, this is getting long. My point is, I know I shouldn't have reacted the way I did, what do I do now? Talk to DS again or not? If yes how do you explain why you can't play naked with others? Or can they? Help!