It's going to come down to what SK definition of "functional" is. Epic will claim that their engine was "functional".
Epic did have a functional version of the Engine in March. We know this because this was the month Microsoft themselves would start using the UE3 engine. You might remember this quote from Shame Kim "We only work with the best partners and utilize the best technologies, and Epic and the Unreal Engine 3 hit the mark on both those fronts" said Shane Kim, General Manager, Microsoft Game Studios.
SK is just arguing that because the version of the engine they finally revealed with the Gears of War source code was "more functional" than what they had access to prior, the UE3 engine was not "truly" functional until that date.
Epic had no obligation to release the Gears source code. They only did so because they are magnanimous company that has the best of the whole industry in mind. SK would probably have no grounds for litigation at all today if Epic had not had been so generous to them. This is akin to looking a gift horse in the mouth... and then firing a couple rounds off at the guy who gave it to you.
I think as an outsider looking in, you're probably not in a position to be claiming who is in the right or wrong. For all you know, the tools Epic provided to SK were mostly broken and unusable and parts of the code wouldn't compile or run on the 360. That's what the courts are for.