I think your response is pretty natural, but I don't know that there is much you can do. You can refuse to be "just friends" with them or you can be friends and deal with the issues at hand.
What does his wife want to do? Is she going to be satisfied going back to being just friends? How is their marriage? Has he sought help to overcome his jealousy or deal with his possessive behavior?
I would think a good first step would be for his wife to make it clear to him, in no uncertain terms, that she is not "his". She is not anybody's but her own. He does not control her, he does not own her, he does not get to decide out of nowhere to rock her world upside down. If he was having issues, he needed to talk to her and to you and your wife.
It sounds like he could have some underlying insecurities on top of the possessive behaviors (or maybe that's the cause of them). Has he ever sought counseling to help him deal with it?
What do you want to do? What does she (his wife) want to do? Has he been able to communicate what he is uncomfortable with? It sounds like you all just need to talk it through, and if he really isn't comfortable having a poly relationship, then his wife has the option to either accept that and go back to things as they were or to leave the relationship with him to pursue one with you/find a new partner. You and your wife have to decide whether or not you could continue having a friendship with them if they opt out of poly or if you would need to separate completely with them.