I'm surprised they couldn't find someone with even a rudimentary understanding of diffusion models to review this.
In fact, this only works because the source images are given as input to the forward process - thus, the details being interpolated are from the inputs not from the model. If you look at Appendix Figure 9 from the same paper (https://arxiv.org/pdf/2006.11239.pdf) it is clear what's going on. Only when you take a smaller number of diffusing (q) steps can you successfully interpolate. When you take a large number of diffusing steps (top row of figure 9), all of the information from the input images is lost, and the "interpolations" are now just novel samples.
It's very hard for me to find a reason to include Figure 8 but not Figure 9 in their lawsuit that isn't either a complete lack of understanding, or intentional deception.