OP I am just so so so impressed with how you're continuing to think this through and handle it. I am someone who also really likes to know *exactly* what the right thing to do is and it is SO frustrating when something as important as this is so hard to figure out in terms of what the right thing to do for your family is!
So I commend you for keeping such a level head (even when internally you felt like screaming and trashing the place!) and continuing to just try and try and try to think this through.
Sounds to me like your steps between the last update and the most recent are great. You're watching your son, you're trying not to make too much of a deal out of this while also making sure he understands going forward what's ok and what's not. You've checked out how he feels about the incident without making him feel like he's being interrogated. And most importantly of all: you're maintaining normalcy in the rest of his life and watching how he does. And loving him and your daughter loads, of course!
You already know how I feel about contact with the nephew so you know I think your plan sounds exactly right: keep dealing with your own son, counseling for you (and are you thinking of going with your sis and son, or with your sis alone? I wasn't clear on your counseling plan), and for your son's benefit trying to figure out some safe contact with his cousin, even if it's greatly reduced and ALWAYS supervised. As you've read there are a lot of different opinions about that, but in both my personal and professional experience (and given the details of what happened here and the circumstances and your sister taking responsibility for her son) given all that if I was your caseworker I would absolutely approve of contact between your son and his nephew as long as it's supervised. I would agree because I've seen how it can hurt a child more to have a relationship that's important to him severed completely, no matter how sensitive/good/creative the explanation is. Would he get over it at some point and be fine? Probably yes. But just like the poster who still remembers being told an older sibling/relative wanted friends their own age and the sting of that, it makes so much sense to allow some contact if it can be done safely and your son seems to benefit from it.
Honestly, as great a mom as you sound and as hard as your sister is trying to help her son, I'd say that relationship between your son and nephew - if you let them keep contact - will be one of the BEST supervised relationships ever!
You're super brave and a wonderful parent. There are so many wonderful parents here, I am so glad this place exists. And I'm not only talking about the mommies here I agree with!