I think they are correct, Apple could reject their app based on the TOS. Its unclear whether or not they would. I imagine this will be rather murky for a while for all apps of this sort.
What I mean by not the real deal though is that TinyGrab doesn't appear to have much of a presence on iOS devices. Apple could have possibly said, "We need 200 hours of additional programming work from you or we'll reject your app in the future" and they may have bailed. One indicator of this is their complaints of the $99 developer fee. I think most successful companies would welcome a small yearly fee simply because it would reduce the number of low quality competing apps entering their market place. A small yearly fee helps ensure to some degree that the app developer has some serious intentions to create something meaningful.
A lot of the complaining is fully justified. There are other cases like Rhapsody where the company has over 700k subscribers in the US and the CEO has admitted most of these users listen to Rhapsody through an iOS device. That has real implications for them as a subscriber service with small margins. In TinyGrab's case though, they could work around the terms of service and still provide access to their user base. They might have to take a large cut in their subscription fee, or increase their prices, but for a basic screenshot/share service they have options.
The fact they are not pursuing those options, or at least publicly saying they won't be, indicates to me they either have a smart PR team that realized the opportunity here or they just are not successful enough on iOS to justify continuing anyways.