Yeah, I'd agree, this isn't appropriate. However, since he's already seen it, I'd definitely make sure you turn it into a "teaching moment" for him... talk about what he's seen, your values with regard to guns and killing, the purpose of the military and your beliefs/values in that area... also good to talk about death. And why you've changed your mind about playing it. (Don't blame grandma... talk about YOUR reasons, if that's what you choose to do.) My husband and I aren't as much into "censoring" as most parents seem to be... instead, we talk about what we've seen and experienced. Obviously, we don't let our little ones watch inappropriate television, etc., (then again, I also think our version of "appropriate" isn't always the same as other parents... I don't shut a show off because one child calls another "stupid-head," but I do explain to my children that's not kind or loving, and therefore, not how we behave. Clearly, I'm present for nearly every show/game they watch/play... so I'm very much a part of it all at the moment... I figure I won't always be, so I might as well teach them how to respond/behave using the tools of tv and games...) But we feel that when our children are exposed to it, the best response is to GIVE a response, to make it a family teaching moment. Because of television, video games, other kids, (and one little boy who lost a baby sibling and told about it in Sunday school), etc., my son has had many questions about death and heaven, etc., and we've already had lots of good discussions and he's only 4. I feel confident, because of these discussions, that my son is already well equipped to deal with and understand these sorts of tragedies in a healthy way that many adults are not, as a result. So, while I wouldn't condone playing the game anymore, I'd definitely talk about it. Don't think your little man can't understand your reasons, if you take the time to explain it to him as best you can. Also, think about finding a replacement. I agree that Lego xbox 360 games are good, and fun... Obviously, there are still guns and death involved there, too... but not quite so "realistic" and desensitizing. Or try one of those Jumpstart Preschool games available at Best Buy and Target, which is more educational-oriented but still fun.
Anyway, hope you don't take all the "oh my gosh, I can't believe you let him play that!" too personally. :) My little boy has seen my husband play the very same game and so we've had that "teaching moment," too, and Daddy now plays only when our little man is sleeping. But you know, my in-laws didn't let my husband play with guns growing up -- no toy guns, I mean, not even squirt guns -- until he was nearly a teenager. But, he said, he "made" guns out of everything, legos, sticks, Construx, etc. :) And I think my husband turned out just fine for "making" his own guns... even if he does like playing this game. :) And did join the military (but does not carry or use a gun). I sort of think boys will be boys in some ways. Just this particular game is pretty life-like... esp for a five year old... and with summer on the way, there are lots of alternative activities: swimming, soccer, roller-skating, biking, hiking, karate... :)
PS -- if you want a really good read on "boys will be boys" -- understanding your son and your husband -- check out "Wild at Heart." LOVE that book, and when I read it, and was recapping to my husband, he said "wow, that's right on... I never thought of it that way, but that's right on." So... check it out. :) I think your boys will appreciate it. (PPS -- the woman's book is "Captivating," also really great!)