The hair-splitting begins. The phrase "software development" in my book, and I suspect in most people's, implies code. If you just mean any old development, well, sure, the customer development was proceeding quite nicely. Maybe that was what they meant?

Try a simple thought experiment. If the customers learned that there was no code and the product consisted of nothing more than the printed "screenshots" they'd been shown, would they care? I'd guess that one's answer to that is pretty correlated with whether or not one thinks deception was involved here. My answer - not about these particular customers, but in general - is yes, they would care. As a customer, I certainly would. (Not, of course, because of any objection to paper prototyping as such, but because a critical piece of the situation had been hidden from me.)

I got a little skeeved out at "development is coming along nicely", just like you, but the solution to that is just to choose better words. They could simply have said "design is coming along nicely", nobody would have cared, and they'd have the exact same outcome. So while you're right that those were unfortunate words, it's hard for me to get too bent out of shape about them.

There isn't enough information in the story to know what was really going on. Some possible contexts are a lot more venial than others. I think what irritated me was just the gloating tone of "we sure put one over on them"... but perhaps they didn't mean it that way.