Sorry to hear that. Especially as the logo was developing nicely. So no, your logo wasn't "THAT" bad as you say.
It could be one of a hundred reasons why they went with someone else. They could have asked a lot of people to submit proposals as freebies, before deciding to pay for the one they liked. It could be that someone they know personally has piped up and said, "I can do that."
Don't let it get you down, and don't take it as an affront to your work.
I know most of us have probably done freebies from time to time, for various reasons, and it can be a way of getting paid work further down the line. But it does leave you open to this sort of thing happening when there is no formal agreement, or the client starts off feeling like they don't owe you anything.
At least you've got another portfolio sample out of it, if you choose to take it further, and you might approach free work with a bit more caution now? It's best to try and learn from these things rather than letting them grind down your confidence.
I also agree with Chris, keep an eye out for the logo they do go with to make sure they haven't pulled a fast one.
Does anyone know anything Ross can do to prove it was his idea first? If it came down to an argument. The only trick I remember is putting printouts and an artwork disc in the post, sending it to yourself making sure it gets a good dated postmark, then leaving it sealed when it arrives back to you. Not really sure if that will prove anything though.