The spanking part I can understand as kids being kids and playing "house" (Even though we do not discipline our son in that way)...the part that really concerned me was when she had him insert the spatula in her butt. I guess it was more her butt crack. As soon as we came home I talked with him about not touching and clothes staying on but as I mentioned he's only 3 so how much sunk in, I'm not sure but I'm going to keep mentioning those issues as time goes on. I just don't know what to think about that part of it all.
Sounds like they may have been playing "house" and she was in trouble. In my opinion, it is going too far, but not because the little girl was being inappropriate as much as beating a child with a utensil on the rear is inappropriate. Children use dramatic play to explore social and family roles and she is probably reflecting her experiences. It doesn't sound like it was sexual in nature.
This is a very appropriate opportunity to speak to your son about private parts of the body, and how he needs to respect those parts of other people's bodies, and they need to respect his. Add that since we would never really want to hurt a person, it is not OK to even pretend to hurt them. As for the other child's grandparents, I would simply report what I saw without any judgement or implications of judgement. "I just wanted to let you know that I saw Suzie had pulled her pants down and asked Johnny to whack her bottom with a spatula." The break the tension you can add laughingly "you sure don't want her doing that in school so you may want to discuss it!"