I've never ever heard of mufflers causing an issue with a warranty. Call their bluff and let the warranty "inspector" do his thing. Given the history of the 07/08 bikes and motors, I think you should make sure they know that you know of all the issues, and ask for a new motor... I wouldn't spend the money on a lawyer until you've exhausted your options with the MOCO....
....The warranty inspectors are third party inspectors that only come out to verify the claimed damages. They then report back to the warranty company with findings. We have never had a claim denied due to aftermarket exhaust. From the sound of things you need to find a more competant shop to the repairs correctly so you are not back again.
In April of ’09 I saw an ESP claim for shifted flywheels on a 2006 Road King held up by CNA for a set of slip-on mufflers. The claim was eventually paid, after some fooling around, but it could have easily gone the other way. My sense is that once they dig their heels in, it will take some muscle to get the issue resolved, if it is even possible to do so. The fine print always seems to make this sort of thing real difficult.
As I remember it, the adjuster was aware that the machine had a Stage-2 big bore, and that it was not the street legal kit. I believe that he even checked the ECM for a street legal download. The process stalled when the adjuster asked to see the mufflers, by part number, from the street legal kit.
I will even recommend removing a trailer hitch from a machine with an issue significant enough to require an inspection. It seems that this environment has evolved over time into this fussy inflexible sort of thing; it wasn’t like this 5 years ago.
I’m truly surprised that things in hd-dude’s neighborhood are more relaxed. I always assumed that California was ground zero for all that is regulated. Issues like these must be up to the individual adjuster’s discretion.