So it would seem that my best course of action is to:
1) Remove the offending image immediately
2) Reply to the letter along the lines you suggest
Do you think to would benefit me if mention in my response that I have taken legal advice?
Also, is there any particular form of words you could suggest - or refer me to - which would add weight to my response, over and above your comments above?
Do you think it would be worth my while offering them, say, £100-£200 on a without prejudice basis to settle immediately?
Finally, if they continue to play hardball and we can't agree on a 'reasonable' settlement, what should I do next?
That's all the questions I think!