The New City Software system establishes a gaming environment in which players get to build superhero characters. Some players, naturally enough, have built characters resembling certain Marvel characters, in one or more of name, appearance, powers, and weaknesses. Marvel is rather disturbed by this. Except for the interactivity, this is precisely the problem that much (not all, but much) fan fiction presents for its authorized creators.
This leaves a simple question: How close is too close so that it's unfair to the creator? (Did you really expect a definitive answer to that? I thought not.) Under a copyright theory, it's "too close" if one might choose New Soft's product as a replacement for Marvel's product. There's a lot of fancy rhetoric dancing around there, but when these things actually get to a factfinder that's what it seems to come down to. (There are also exceptions, such as Air Pirates—but, as I noted a while back, Air Pirates may no longer be good law.) The problem in this instance is that the two products are in different media: One is an online multiplayer roleplaying game, the other is centered on comic books (although also including films, etc.). That makes the "replacement" theory very difficult to evaluate, because the media characteristics are probably at least as important as anything else.
That's how copyright law works. It does require replacement; even if the infringing material is "free," choosing it as a replacement is a replacement. (Yes, I know it's a tautology, but in about 800 words or so you'll see why there's little choice in terminology.) That, however, is not the only thing that fan fiction does. As noted above, fan fiction can foreclose otherwise profitable continuations to the authorized creator; it can confuse potential consumers as to what is "canonical" material; and it can have a number of other harmful effects on the authorized creations, even without intending to harm anything. That should sound a lot like "unfair competition" causes of action under the common law; and indeed it is. "Unfair competition," though, doesn't go far enough—because most fan fiction isn't intended to enter the stream of commerce.
So that leads us back to trademark law, where I predicted we'd end up. Trademark law as we know it originated among silversmiths in London's East End, who put their own marks on their wares to show that they were a certain quality of goods. Counterfeiting of marks was actually a criminal offense; the 17th-century equivalent of cheap Singaporese knockoffs of "No Exit" apparel wasn't a matter for a lawsuit! Modern trademark theory posits three possible ways that false marks can harm the markholder. The obvious one parallels the copyright issue in New City Software: substitution. A mark is infringing if the "least sophisticated consumer" might be fooled into choosing the unauthorized goods or services over the authorized goods or services. That doesn't help us much; the other two trademark theories, though, do.