Gordon Bishop, for Newcastle City Council and four experts, said some children had developed fears and phobias while many began to have violent and disturbing nightmares.
They are suing the council and Richard Barker, Judith Jones, Roy Wardell and Jacqui Saradjian who wrote a council-commissioned report, published in 1998.
The four concluded Mr Lillie and Ms Reed had sexually, physically and emotionally abused a large number of young children whose care had been entrusted to them.
Four years earlier, they had been acquitted of indecently assaulting young children at the nursery.
The former workers also are suing the Newcastle Chronicle and Journal Limited for libel over numerous articles published after the report's release.
Mr Bishop has told Mr justice Eady, who is hearing the case without a jury, that the four experts still firmly believed Mr Lillie and Ms Reed sexually abused the children.
Setting out the background to the investigation, the barrister said that in April 1993 a mother of a two-year-old boy went to police complaining he had been hurt by Mr Lillie.
But Mr Bishop said for some months prior to that a number of parents began to notice that their children were behaving unusually.
'Children who had previously been toilet trained and dry during the day and/or night began wetting themselves again.
'Children would not sleep in their own rooms; they developed fears and phobias, particularly of clowns, libraries and going to the toilet,' he said.
'A large number of children began to have violent and disturbing nightmares, one screaming 'Chris don't do that', and another shouting 'my fairy's sore' and another waking up screaming and crying that a clown was going to get her.
'Parents and staff noticed that certain children would undress themselves at inappropriate times while at the nursery.'
Mr Bishop said although many of these symptoms and statements were noted at the time, few parents recognised them as signs of sexual or physical abuse or connected them specifically with the nursery.
Earlier, he referred to the case of a student nurse at Newcastle College, Jason Dabbs, who in July 1992 confessed to having abused numerous children at one of two nurseries in which he had a placement.
In April 1993, he was sentenced to seven years imprisonment.
Mr Bishop said Mr Lillie and Ms Reed suggested that this case led to the claims of abuse being made against them in this case.
'In fact, the Dabbs case shows that widespread sexaul abuse of multiple children can and does occur in day nurseries,' he said.
The four experts still firmly believed two former nursery workers had sexually, emotionally and physically abused very young children in their care.
Gordon Bishop, for the experts and Newcastle City Council, said the four stood by their abuse conclusions made in a 1998 report about Shieldfield Nursery.
In his opening address, Mr Bishop told Mr justice Eady that whatever decision he made there was no doubt very young children who attended the nursery were the innocent victims.
'There can be no doubt, I submit, on the evidence that a large number of those children not only made statements that Chris Lillie and Dawn Reed sexually abused them but also were traumatised and suffered very great distress over what occurred,' he said.
He referred to the cases of 27 children, of whom he said 19 had displayed sexualized behaviour.
Over a three year period, the four member review team had 'carefully and thoroughly investigated' what had happened before concluding the two workers had sexually abused children.
'They believed then and believe now that is what happened,' he said, telling the judge of evidence - including testimony from three experts - which he said would clearly establish that to be the case.
Mr Lillie's and Ms Reed's case appeared to be that in most instances the distress, trauma and sexualized behaviour of the children was caused by them being asked leading questions by parents, social workers and others and then encouraged to give answers indicating abuse.
Further, Mr Bishop said their case appeared to be that the children then believed they had been abused leading them to have nightmares and develop various behaviours.
Whether the former workers were found to be right in declaring their innocence or the review team right in finding they abused children, Mr Bishop said there was no doubt the matter was of great public concern.
He said it had required a full investigation, not least because parents had made complaints about a council-run nursery.
'For that reason in August 1995, the council appointed the review team as a highly qualified totally independent tribunal to investigate what happened at the nursery between January 1988 and Janaury 1994,' he said.
The four appointees were Dr Barker, then head of the division of child and family studies at the University of Northumbria, Ms Jones, a former child protection officer, Ms Saradjian, consultant clinical psychologist and Mr Wardell, a former local government director of social services.
Mr Bishop said the council and review team were under a duty to ensure an investigation was carried out. The council was then under a duty to provide copies of the report to parents and other persons who had an interest.
Further, he said that under the Local Government Act the council had a duty to make copies available to the press.
'The review team does not believe it came to the wrong conclusion, it firmly believes it came to the right conclusion,' he said.
Even if they were wrong, he said the report was fully protected by 'qualified privilege', meaning it could not be the basis of a successful defamation action.
But Mr Lillie and Ms Reed have submitted such a privilege is negated because the council and review team acted 'maliciously', writing and publishing it for some dominant, improper motive.
'That allegation, as the claimants must be aware, is wholly unfounded,' said Mr Bishop.
'There is not a shred of evidence to support it and it should be withdrawn.'
A newspaper had been perfectly entitled to tell its readers about the report which came to the 'most devastating and sickening' conclusions about two nursery workers.
Numerous articles were printed in the Evening Chronicle after the 1998 release of the report titled 'Abuse in Early Years'. Victoria Sharp, for the Newcastle Journal and Chronicle Limited, said if there was ever a case when a local newspaper was entitled to publish findings of a report and follow it up in detail 'this was it'.
In her opening address Miss Sharp said the report was the product of three-and-a-half years work by four independent people, paid for by local taxpayers at a cost of more than half-a-million pounds.
'The report came to the most devastating and sickening conclusions exposing a scandal at the heart of local government of epic proportions,' she said.
It received blanket media coverage around the country and was commented on by numerous people and organisations including community members, MPs and parents.
Miss Sharp said that to the people of Newcastle, and parents generally, the report must 'have made their blood run cold'.
Parents thought they could leave their children safely in a nursery, not have them taken away and 'their innocence defiled and trust betrayed in the most sickening way', she said.
The publisher claims the report was protected from libel action by 'qualified privilege' and also claims the sexual abuse conclusions were 'justified'.
Miss Sharp said that in some ways local government had a more direct impact on people's daily lives than national government.
'It is absolutely vital that ordinary members of the public are kept informed precisely on what is going on,' she said.
'Keeping the public alerted and informed was precisely what the Evening Chronicle did.
'This was a story of huge importance to the local community in Newcastle for whom the findings of the report had the most profound implications.'
But the report was the beginning of the story, not the end, she said. The paper continued its coverage with follow-ups involving questions about local government and numerous other issues.
'Our submission is that there was the clearest public benefit and public concern in the publication of the findings of the report and in particular that Mr Lillie and Ms Reed were multiple abusers of young children,' she said.
'We would say it is genuinely difficult to imagine a report which would be of greater public concern, in particular to the local community.'
Miss Sharp rejected a submission that the paper should have realised the report was fundamentally flawed and therefore not have reported on it. It was not the publisher's job to re-do the report, she said.
The case is continuing.
STRAND NEWS SERVICE