"Copyright law is supposed to encourage artists to create new work"
By discouraging other people from reproducing their work without permission and/or compensation, yes.
Someone got jumped on for reproducing a work at a lower quality. Whether it was a photoshop filter and/or hand placement of a few pixels doesn't matter; it was recognizably reproducing the work. This wasn't some new piece of art that got them sued, this was a particular reproduction of a 50-year-old photograph.
There's a significant difference between something like this and, well, covering a song as a chiptune. If you cover a song and try to sell that, you have to make arrangements to compensate the songwriter or rights owner. This is just appropriating an original work and hoping nobody notices.