@kwanzaabot
no, illegal is NOT an overstatement.
Fair use has a lot of restrictions that are often ignored by those who claim it - especially when it comes to using other people artwork those restrictions are extreme. For example you are restricted in the reason why you use something, and "game making" is NOT one of those reasons.
The ONLY reason that is allowed by fair use and that might apply to game making is the "Parody", which means the game has to be a targeted parody of the source for the resource you're using. Using a resource in a game that is not a parody of the source of the resource cannot claim fair use under any case - and "transformative work" is also something specific that you cannot use in this context.
You could use your explanation ("transformative work fair use") to use the modified sprite in a tutorial telling people how to transform graohics into valid sprites (that would also count as the "educational" requirement of fair use), but you CANNOT use the resulting sprite in a game, because that would no longer fit the reason behind that part of fair use.
And never forget that fair use is a defense, not a right, from a legal viewpoint. Which means you can claim that after you already have been sued and had to pay for your lawyers. Of course you can get that money back after you have won - but winning isn't always sure, especially if you fall prey to some of the more idiotic misconceptions about fair use laws. And it doesn't change that you often have to put the money up front to pay your lawyer before he can get you that defense.
EDIT:
and yes, ripping is always illegal - the reason why people get away with so many fangames of ripped resources is that the IP laws are civil laws, not criminal laws.
Which means as a result that only the IP-Holder (no one else) can initiate the lawsuit and legal processes. And to do that the IP-Holder needs to know of a copyright infringment to sue in the first place - most of the mentioned games are too obscure to be known in Japan, because you have to hunt for them.
And second, same as above for the defense - the IP holder needs to pay his lawyers for starting the process as well, which would be lost money if the kiddy who made the illegal game doesn't have the money to pay the fines.
They still go after ripped games in those cases where they become widely known however, because not going against a commonly known copyright infringment will void their copyright in most countries - but they don't throw away money for every minor infringment around.
But an unknown game using ripped resources is still illegal and the IP holder can go against it whenever he chooses (or when the game becomes known to him)
