Who would set up a contract releasing a developer from all obligations, prior to app acceptance, on the handwavy notion that the dev would fix it for free outside of contract?

That's just... not how business works. Milestones are organised such that the client can get the things he values with a reasonable probability. Even setting the milestones up as he did is risky, since the dev could just have decided to take 3/4, ship crappy code, and disappear into the interwebs. I guess in this case the client was relying on the reputation system of e-lance and the relatively small amount of money involved, but still.... when I read that he'd agreed to the final payment on such a flimsy acceptance clause I was ready to read a really bad end to this.

Not sure why people are emphasising the money so much. For a dev in NYC $800 is very little. For a guy in China that's a much better deal. Kind of the whole point of using e-lance, no?