I don't want to sound too harsh or like a jackass in this post, but I want to state something I learned on the my law classes, but it's not like I needed them to know.
If it is illegal, then it is illegal. Period
All arguments have already been discussed here, and they are only favorable to square-enix. As such, I would like to set clear something, and there is no "perhaps", "but" or "maybe..." on these:
1) Using the Final Fantasy name is illegal.
2) Don't matter if the project is for non-profit, educational, small or whatever, this won't stop it from being illegal.
3) Using any of the original characters, their script, their names, their designs on purpose, and we are doing on purpose, is illegal. We can "cheat" this by changing names, but this is just a legal hole.
4) Everything illegal, no matter how futile it may seem, is still illegal.
5) These laws may change from country to country. I don't know if what my german friend remains true, but while there are countries whose international policy is quite closed (RIAA can't sue a russian for pirating mp3s, *AFAIK*), most countries have signed agreements to stablish an international law. These same rules apply to Japan, US and Brazil, and with 80% of chance, on your country.
6) Using or modifying the original files, and let me repeat: the use of the original files for anything other than having the original FF7 played, or the modifying of it at all is illegal and this includes, but is not limited to:
6.1) The Chocobo Patch, which received a "green card" from Eidos because they actually won't care about this game anymore.
6.2) Any tool ever written to extract or see the files of FF7.
6.3) Any tool ever written to edit the files of FF7.
6.a) If we are writting our own engine, using their files would be kinda pointless.. imo.
7) FF7 is the intellectual property of Square-Enix. Not ours. Period.
Well, with these things clear, the production of an engine have 3 possible outcomes:
1) Don't really caring about it at all and doing on secret.
2) Moving every file to a server somewhere in a country with a closed international policy, making the official author of the project someone from this country, and letting the rest not having any "official" contact with the project.
3) Asking license to Square-Enix in the most strategic and well thought manner possible.
Now, an analysis of these options.
The first option is really the easiest. Why don't Square-Enix close the sites of Qhimm, Ficedula, Alhexx and others? I really doubt they have *never* seen these sites. It's because it won't matter. Not that they would care, they can just mass-send a generic C&D e-mail anyway, but I don't think this is costing them any money (like most fan sites which release OSTs to download. Each OST downloaded is an OST less bought).
The second option while morally illegal, would not allow, as far as I know, let Square-Enix do anything about it, if the right country is choosen. This is the same strategy as MANY politicians use to send their money, or that many mp3 sites use in order to get a complete and full imunity from RIAA. And keep in mind they are far bigger than Squaresoft.
The third option is the most "right", and at the same time the one with less chances of success but, if suceeded, we would have no legal barriers and this would ease a lot the work. Writting the letter to send them would be a full-scale militar operation.
That is it. I might have missed something. But please people, don't discuss what is illegal or not. If it messes with their product, then it is, simple.