B.
Sex is just a 3 letter word for a 5 year old; sex is a huge issue for adults, especially parents who don't want their children growing up too quickly.
What the other girl knows about sex may be as little as that 3 letter word. You really don't know. What you do know is that she had a dream (or said she had a dream) and in her dream the other kids (your son) were having sex. Does anyone know what she meant? Could she define the word sex? Does she think that sex is intercourse? Do you? Sex, as you explained to your son, is gender identity as well as many other definitions.
She might think that sex means laying beside each other. She might think that sex means holding hands. She might think that sex means kissing. She might think that sex is rubbing noses. You concluded that she meant sex was intercourse from the message in your letter.
Children talk about things today that we adults never thought about until we were teens or older. They are exposed to sex in wholesome and violent forms through TV, advertising, movies, magazines, children from dysfuntional families, etc. You can control your home, but school and the neighborhood is full of good and less desirable talk.
While you cannot control his environment completely, you can develop a positive attitude about giving your son healthy, appropriate, honest information. Appropriate information keeps children, and adults, in good shape. Lack of information leads children, and adults, into difficult and problematic situations.
A young child can be a sexual child. Awareness of their body, observation of their parents and other close family adult friends (holding hands, playful physical contact, hugging, kissing -- socially appropriate behavior of course) teaches them to feel good about themselves and their bodies as well as their own sexual activity at a much later time when it's appropriate. They are learning now how to behave in later years. They are learning now from you how about decisions they will make in later years.
Getting too upset about this though is going to send poor messages to your son, even the unspoken feelings get through to them loud and clear. If you can begin to think about this in a way that's informational rather than anger, you will be a concerned parent who wishes her child to learn about sex in healthy, appropriate ways.
You're a good mom who's hit a bump along the road of parenting, but asking others is a huge acknowledgment to you!!! Three cheers!!! Parenting is a really tough job; the hardest job you'll ever have bringing you the greatest joy as well as the most pain.