You can flump all you like powell, but it is you who posted a very confusing question.
As I read it from bits and pieces... you were out walking with your dog and so was your friend with his dog. Your dog has been friendly to your friend's dog. Then your dog attacked the terrier and caused serious injury.
If this is correct, you are totally responsible for the Vet's bill and $2k is not excessive with serious damage like 'a leg hanging off'. Beside the tooth marsk you saw, there was no doubt internal damage.
That the terrier bit your knee in these circumstances is not a redeeming sign but rather that the poor beastie was completely terrified. You get no brownie points for that.
I hope that when all this is settled, your dog has not been put down.