OtherOS originally existed so Sony could claim the PS3 was a computer, which put it into a lower tariff category than a game console in Europe. They never offered it on the PS3 Slim (launched in September 2009) because by that point Sony had gotten the price on the system down enough that the difference in taxes didn't matter to them, but they continued supporting it on the PS3 Fat. This was all legal because Sony never advertised OtherOS support on the Slim.

Sony only removed OtherOS on the Fat after George Hotz discovered and published an exploit that allowed users to break out of the OtherOS sandbox and gain full control over the PS3. This allowed running custom firmware and pirating games with a bit of additional work. Sony judged that they couldn't patch the exploit without disabling access to OtherOS entirely, so that's what they did. Hotz announced his exploit in January 2010 (https://web.archive.org/web/20100129034435/http://geohotps3....), the Yellow Dog Linux team posted a rumor that Sony was getting rid of OtherOS in February 2010 (https://www.xtremeps3.com/2010/02/20/rumor-alert-otheros-to-...), and Sony officially announced the removal of OtherOS due to security concerns in late March 2010 (https://blog.playstation.com/2010/03/28/ps3-firmware-v3-21-u...). As you say, this removal was later found to be illegal in court.