As usual, multiple parties are shooting their mouths off, proclaiming that theirs is the high-moral-ground principled position. Artist B remarks that "I do not, however, regret the images I created, or the way in which they were made. When we as a society lose the ability to comment on what we see and to have an opinion on what we are exposed to, then we have all lost what makes us unique on this planet." Photographer A feels that the trust between she and her subjects has been violated by a third party (as an aside, Photographer A and Artist B have previously been involved in a somewhat similar dispute). The university, of course, is expressing deep regret at any hurt feelings this may have caused. Meanwhile, the subjects of Photographer A's photograph have wisely said not a word. Complicating things, though, Artist B indicates that he drew his "additional material" from another photograph by an unspecified photographer, which leads off on interesting tangents all by itself.
This runs directly into the unsettled, and unsettling, question of "transformative use." If I had to guess, without having had access to the pictures at issue, I would characterize this as closer to the Tony Twist problem than to the Edgar Winter problem. Closer; but the emotional baggage of sexual implications may bring this closer to Walking Mountain. Seems like a good test question, eh? The point is this: There is no bright-line test for "acceptable parodic use." Militating against the artist is the use of "hyperrealistic" technique to closely reproduce lighting and texture of a photograph, which makes his work a derivative of the photograph. However, he certainly added "value" of his own by blending in another figure. Whether a photograph of three young boys is so "stereotypical" that it's like a photograph of Barbie is clearly a question for somebody who cares about these sorts of things more than do I.
In any event, I'd put a sawbuck on a settlement here, but mainly due to the history between the two parties. It's definitely an issue that bears careful consideration at the intersection of personal privacy, the First Amendment, copyright, trademark, and rights of publicity. Not to mention stupid gallery supervisors who didn't ask the artist whether he had model releases in hand… but that's for another time.