Simply because a rights owner chooses not to enforce their copyright (acquiescence - think the fan made Portal prequel) or chooses to subsequently adopt the unauthorized derivative work and distribute it to their benefit (Think Black Mesa) doesn't make the underlying work not infringing. Rights holders choosing not to sue to enforce their copyright is not the same as fair use.
Quibble about infringement aside, your understanding of the fair use factors is oversimplified. You correctly list the factors, but your analysis falls flat. Let's filter this mod through the four factors and get some case law to back up the analysis.
At its root, Copyright is a "negative" right that allows users to keep others from doing something. 17 U.S.C. §§ 106(1)-(6) of the Copyright Act list the negative rights of a holder.
Here, the mod arguably violates 17 U.S.C. §§ 106(2)-(3) (preparation of a derivative work and distribution of a derivative work). It doesn't matter that the distribution is free. It doesn't matter that it checks for KOTOR game assets and uses those (this isn't an instance where the "first sale doctrine" will save you).
A complete defense to a claim of copyright infringement is fair use. Like you said, it's a four factor balancing test that weighs 1) the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes; 2) the nature of the copyrighted work; 3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and 4) the effect of the use upon the potential market for or value of the copyrighted work. Brownmark Films, LLC v. Comedy Partners, 682 F.3d 687, 689 (7th Cir. 2012).
Let's dive into each factor.
(1) the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes;
This first factor of use draws on “the nature and objects of the selections made”. Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 576 (1994) (citing Folsom v. Marsh, 9 F. Cas. 342, 348 (C.C.D. Mass. 1841)). Also weighed in this first factor is “the commercial or nonprofit character of an activity”; use that is noncommercial is presumed to be less likely to infringe than commercial use. Sony Corp. of Am. v. Universal City Studios, Inc., 464 U.S. 417, 448-49 (1984).
In looking to nature and objects of the selections made, it is important to consider the goal of the factor’s enquiry. The goal of the factor’s enquiry is to determine “…whether a new work supersedes the object of original creation, or whether it adds something new, with a further purpose or different character, altering the first with new expression, meaning, or message”. Campbell, 510 U.S. at 579 (citing Folsom, 9 F. Cas. at 348; Harper and Row Publishers, Inc. v. Nation Enterprises, 471 U.S. 539, 562 (1985) (“supplanting” the original)). If the new work does not supersede the object or original creation and it adds something new with a further purpose or different character that alters the first with new expression, meaning, or message, the use is considered transformative and “…such “transformative” works lie at the heart of the fair use doctrine’s guarantee of breathing space within the confines of copyright”. Campbell, 510 U.S. at 579.
Out of the gates, this dev has the noncommercial nature of the work on his side. However, note that a work's "transformativeness" is rooted in its market relation to the underlying work. Does this re-release add something new? Absolutely. Is that addition creative and expressive? Absolutely. However, in a legal sense, this game merely "supplants the original" because its a high-def remake of the game that literally takes the assets from the underlying work. Even if a person made a game that was a remake that used NO assets from the original game, it would get hung up on Rowe's supplantation of the original argument. This remake would arguably supercede the original (Why would I play my shitty old version of KOTOR if I can just play this remake?) The fact that you need to have a copy of KOTOR to play would help undercut this, but it wouldn't carry the day in court. The derivative work would still be supplanting the original. Once we get to factor four, you'll see why there's no respite in needing to own a copy of KOTOR to play.
(2) the nature of the copyrighted work;
The second factor of fair use is an inquiry into the nature of the underlying copyrighted work.
The core of copyrightable works lie in creative expression. Works that are mostly factual have less protection afforded to them than works that are more expressive. See, e.g., Feist Publications, Inc. v. Rural Telephone Service Company, Inc., 499 U.S. 340, 349 (1991) (noting that “…the copyright in a factual compilation is thin”); Int'l News Serv. v. Associated Press, 248 U.S. 215, 246 (1918) (noting that facts are not copyrightable); but see Harper and Row Publishers, Inc. v. Nation Enterprises, 471 U.S. 539 (1985) (unpublished memoir manuscript of a U.S. President had the requisite amount of creativity to be afforded copyright protection when copied and published by a newspaper).
Here, analysis is simple. Videogames are highly expressive works (even if they were based on facts, which isn't an issue here). This factor would weigh against the dev here, as the presumptive strength of Disney's copyright is strong.
(3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole;
The third factor of fair use is an inquiry into the amount and substantiality of the portion used in relation to the work as a whole. This is analyzed both quantitatively (the “amount” of the underlying copyrighted work was taken) as well as quantitatively (the “substantiality” of the work taken in relation to the underlying copyrighted work as a whole).
Here you can make all sorts of arguments to doctor up the quantitative prong of this factor. If you look at Feist, you can see examples of this. You could frame it as "I only took the audio assets of the game" vs. "I took 100% of the underlying work's audio assets". Good attorneys could argue this factor either way, so it's genuinely a tossup.
The second consideration weighed in this factor is the substantiality of the portion used by the defendant. The Supreme Court has characterized this qualitative factor by identifying the creative “heart” of the work, and then seeing whether a defendant copied the “heart” of the underlying creative work. Harper and Row Publishers, Inc. v. Nation Enterprises, 471 U.S. 539, 599-600 (1985) (noting defendant had copied the “heart” of plaintiffs unpublished manuscript in weighing the third factor of fair use).
Here, the dev straight up loses. The creative "heart" of the work is the game KOTOR itself. At the end of the day, a slavish copy of another's highly expressive work (whether you make your own textures, source code, develop in another engine, whatever) is still leveraging the uniqueness and awesomeness that is KOTOR, and trying to repackage that "creative heart" under another banner while calling it fair use. Dev would lose on this prong.
(4) the effect of the use upon the potential market for or value of the copyrighted work.
Finally, the fourth factor in fair use analysis is the effect of the use on the potential market for or value of the copyrighted work. Here, both the market for the original copyrighted work as well as derivative works of the original must be considered. See, e.g., Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569 (1994) (considering both the market for derivative works in parody of the song “Pretty Woman” as well as the market for the original song when determining whether a parody of “Pretty Woman” infringed the original artist’s copyright). For both markets, courts ask whether unrestricted and widespread conduct of the sort engaged in by the defendant would result in substantially adverse impact on the potential market for the original works and derivative works based on the original. Id. at 590.
First looking at the market for derivative works, "letting this slide" damages Disney's potential market for derivative works of KOTOR. Disney has the exclusive right under § 106(2) to "prepare derivative works of the original copyrighted work". Disney is the party that has the right to make a remake, reskin, rework of KOTOR. Not anyone else, no matter how much they worked on assets, coding, and development itself. Don't mess with the § 106 rights.
Looking to the second market, the market for the orginal work, the dev could make a creative argument that since the underlying work he's making needs KOTOR to run, it might increase KOTOR's sales so people can play his mod, which positively impacts KOTOR's presence in the original market. However, looking back at factor 1, supra, this is only done so the derivative work can supplant both the original in the market place, so this argument could go either way depending on how the attorneys go at it.
Tying it all together
It's important to note that “[None] of the four statutory factors be treated in isolation, one from another. All are to be explored, and the results weighed together, in the light of the purposes of copyright”. Campbell v. Acuff-Rose Music, Inc., 510 U.S. 569, 578 (1994).
That being said, looking at the totality of the factors, they tip heavily in favor of Disney.
TL;DR: Fleshing out fair use, the dev would lose if it went to court. There are some creative arguments he could make to try and get by, but the law definitely is not on his side. This isn't fair use, it's the preparation of an unauthorized derivative work that infringes on Disney's copyright in KOTOR. Acquiescence and subsequent adoption of infringing mods in other cases doesn't make them fair use. It means that the original copyright holder chose not to enforce their rights.