I think what really happened here is that someone at the Libyan domain authority decided they wanted the name and made up a story in order to seize it. I've heard of other cases of .ly names being confiscated, and for this reason we advise YC startups not to depend on them.
Alternative explanation: http://news.ycombinator.com/item?id=1765420 "Violet Blue is an adult site".
Well 'Violet Blue' is my girlfriend, she's not a website :P
Do you mean "vb.ly"? It certainly was not an adult site - it was a url shortener. Have you not seen the grabs of the site floating around in media?