School officials are right. The SCHOOL owns the paper, just like Rupert Murdoch owns the New York Post. The students have no First Amendment right to publish whatever they want in it, no matter how many times politically-motivated (LIBERALLY motivated) organizations like the SPLC like to screech otherwise.
He should have been suspended, though I think the banning from the graduation is a bit of overkill.
(But then, high school graduation itself is overrated. Show up, listen to your principal bleat and the valedictorian everyone hates talk about how wonderful he/she is, then stand in line for an hour to be handed a blank piece of paper with a ribbon around it (since the real diplomas won't be printed for weeks or months). Then go out and get wasted. Yay.)
At least he didn't get sent to the re-indoctrination center (sensitivity training). Just remember kids, it's not a crime if you don't get caught.