I greatly appreciate your responses and encouragement. It's been very helpful.
I don't think that my son was being coerced into anything, but I also don't think the neighbor's daughter was innocently pulling him onto herself. They weren't tickling or wrestling, it was very clearly a sexual behavior.
It's something that I am not comfortable with, but at the same time I have been confused. I posted to help clear my mind and refocus. I haven't had to deal with anything where I didn't know if my reaction was because of my upbringing in a conservative society, or because of my instinct. I wanted to hear your responses to see whether they agreed with my strong reaction.
As has been pointed out, in other cultures that kind of play has been accepted and is ok. BUT, as has also been pointed out, that is not our culture and, while I don't want to raise my son entirely the way I was raised, I do think a sense of modesty and appropriateness is important for where we are.
Luckily, the mother and I are close enough, and she is open enough, to be able to sit down and talk. We had a closed-doors (no kids) talk. I certainly didn't blame her daughter; it was the two of them together. And I didn't ask or imply anything along the lines of abuse; if this keeps on, or if things change to where I think that may have been the case, I will do so. She agreed that we need to keep an eye out...not necessarily constantly, that would be almost impossible with all our kids, and see how things progress. She also said that she would casually talk with her daughter to test the waters there and let me know how it goes.
While I want to be consistent - clothes on or clothes off, not sometimes one and then the other - I think outlawmama's right that to completely stop any nudity is a pretty strong message to send about our bodies. My husband and I take our son places where we all swim naked, and my son and I sometimes go to the local pool where we change in the locker rooms and we've talked about girls locker rooms and boys locker rooms and nudity there. He knows that sometimes it isn't appropriate, to be naked. I think that going alone in another room is just another place where nudity is not appropriate right now.
Thank you all again for your input! It feels so good knowing that I can ask something and get such feedback...what a relief!