Thanks all for the responses. Sorry my post seemed to spark a bit of a ding dong... not at all what I intended to happen....
Grace - I think you are right about the three "options".
To be honest, I just don't think DH is in a place where no contact is an option for our family right now. He may be one day, but not now. I don't think this is something I can unilaterally enforce.
It is not just about hurting FIL's feelings (and beleive me, I personally couldn't care less about that really), its more because all of my and DH's concernerns about his father towards children are based pretty much 100% on instinct and gut feelings. Its becasue of how DH and his sister felt and how DH felt when he saw his father touching his halfsister's thigh (and lets be honest, a father is more than allowed to touch the thigh of his own child - most fathers do it totally innocently all the time when they pick up their child, change the nappy etc etc, it was just that DH, at 15, felt that something wasn't right). Both DH and I however 100% trust DH's instinct in this instance. I don't doubt that if DH had a bad gut feeling, it was for a reason. I think the "greyness" of the situation is centred around this really. There is no way we could (or should) "report" FIL because DH had a creepy feeling as a child. And in the same way, for now, I don't think DH is prepared to cut out his father from his life tiotally becasue of these feelings.
However, what we can do is respect DH's instinct and protect our DCs (agree - this is the most important thing). Also, if I or DH felt that anything were "escalating" (i.e. FIL was getting weirder), I think we would consider no contact then.
And of course, if it got to the stage where I though our children were in danger and DH disagreed, I am sure that I would put the children first. I know that DH would ultimitely understand.
The whole finger up DH's bum when he was in his 20s is totally different of course - that was definite, but it wasn't towards a child....
Thanks again for all the responses and sorry that things got heated.