That's  the issue, SK licensed UE3, then droped the license but kept using the code. They decided UE3 wasn't good enough so they had to "write their own engine" and ditched the UE3 license. Then after the game bombed they decided to sue Epic for not putting enough resources into supporting UE3. 

So then during the procedings Epic got the source code to SK's source code and proved that SK had removed all the copyright notices etc, but kept huge chunks of UE3 code without paying for it. So Epic could prove that SK had in fact used UE3 for their games and hadn't had to create a new engine from scratch like they claimed. If they did not Countersue then it would set the precedent that devs could use their code after they had stopped paying the license, so they really had no choice. 

So really SK stole the code and didn't pay for it, soEpic countersued. And the judge decided that they had to get rid of all the code and products containing the code that they didn't pay for. 

So your argument seems to be: fork over tons of cash to defend against what you perceive to be a frivolous lawsuit and just sorta lie there and take it? That's an interesting POV, but I'm prety sure that if someone sued me for dubious reasons, I wouldn't be nearly as sanguine as you are about it, especially if, in discovery, I noticed a whole bunch of my IP in the product(s) the company is suing me over. (After all, Too Human et al shoudln't have had a single shred of UE3 code in them since they, allegedly, were using their own tech.)

SK (read: Dyak) gambled and lost, big time--they have no one to blame for their current circumstances but themselves.

After reading a bunch of shitty incomplete articles, I think I might have figured it out.  SK licensed the UE3 engine for future games, including Too Human.  Epic missed the deadline on providing the complete engine, and never provided promised features.  SK had to modify the engine to get it working as they needed with Too Human.  This is legal under the licensing agreement, and becomes the property of SK.  However, Epic's original parts of the code remain Epic's property.  SK stupidly decided to stop paying licensing fees, which is where they really got themselves in trouble.  That is what ended up losing them the lawsuit.

The whole broken engine is what i dont understand.  Tons of other developers were using unreal engine at the time without any problems.  Silicon Knights were just so incompetent that they couldnt figure it out.

That's not true most third party devs had technical issues in their first UE3 games. The PS3 was hit hardest and some games were ended up cancelled altogether.