Does this mean that microsoft could be keeping copies of the meta data of every file on every windows computer on their servers and doing the search there?
This incident doesn't actually show any local files being sent to MS, however. Online search can be disable with a registry entry, which proves that the online service is not necessary for searching local files. It's far more likely that a connection error for the bing search is just triggering some bug that then prevents local results from being shown.