Afterms reading other responses I realized I was mixing some teen issues into my answers. (My granddaughter is 14 and I'm working out how to work with her.) I agree that not allowing her to continue playing with her is right. I'm glad to read that your daughter accepted it. You are handling this situation in a way that works without hard feelings.
As a retired police officer who investigated sex offenses, I want to tell you that first reporting to the mom was the right thing to do. Her mom's response is also good.
I was a foster parent for a weekend of a preschool girl who had been molested. CSD was hoping that because of my experience I would accept her long term. She acted out sexually. At least 2 foster parents had been unable to continue fostering her. I was not able to keep her long term because my 8yo hated her out of jealousy.
Her case is extreme. I'm not suggesting that this girl will be in foster care. Her mom is doing the right things. I tell you to illustrate that your daughter's friend is responding in a way to be expected. Her counselor will teach her to not do this.
I would only allow this girl to play with my daughter when I was able to closely supervise. I would not give this girl a chance to talk with my daughter privately. That being said I would limit the number of contacts during after school. Your daughter is an age where you are still in control of her social life.
I would not tell my daughter that she couldn't be friends with her but, depending on your daughter's maturity level, I would tell her, in passing, that keeping her safe is your responsibility. I would not make this conversation about her friend nor make the conversation a big deal. It's to just let her know that her safety is a priority for you.
I would not tell her she can't be friends. I see her willingness to stay friends as a positive trait. You want her to be compassionate and accepting of people different than her and her family. However, I would limit their contact. Protect her while allowing her to make her to come to her own decision about what friendship means.This is a lesson that will help her over and over in making friends. Talk about how being with this girl feels. Talk about how you wouldn't keep a friendship with someone who taunts you and asks you to do things you know are not right. Good that you've been talking to her about friendship. I suggest that in a short time she will let go of this friendship. I suggest that these conversations just be a part of everyday life.
I suggest that if you tell her she can't be friends the lesson will be lost. This is an opportunity for you to guide her in the direction of your values.
About the taunting/teasing at school I would again talk with her mother. She has shown that she accepts information and responds in a positive way. I would also talk with the teacher about your daughter's experiences with her. I would not talk about what has happened in her life. This should be kept confidential. I would expect the school already knows. CSD and the police are committed to keeping all children safe.
Of course, answer your daughter's questions honestly at a level that she can understand. No need to make your answers give more information than she needs to know. Keep being open to hearing what she has to say.
Good you talk about good touches/bad touches. If you don't have a book that is written for children I would get one. a book with pictures is another way to teach.