Don't sever the friendship, but do supervise their time together. That doesn't mean that you have to be right in front of them every minute that they are together, but check on them, keep them within hearing.
I have three sons, and I'm an assistant scoutmaster with a boy scout troop. For 15 years I've been volunteering with boys from the ages of 6 to 18. I've heard a lot of conversations between the boys, I've seen my own sons go through this exciting period, as well. I think you probably have assessed the situation well. The boy is a little older and he is becoming more aware of girls, but he probably doesn't really know what to do with all of the new feelings. When you factor in the messages that bombard the kids about sex, it really is overload. Cutting the kids off from each other won't teach them what to do with all of this information and emotion. I think generally, we parents need to spend lots and lots of time talking to our kids about this very beginning awareness. And we have to tell them exactly what it feels like. "You know, when you first start liking boys/girls, it feels great to be noticed. If they touch you or kiss you, you get a really nice tingling feeling, and you really start wishing that you could touch more and be with the other person more." etc. etc. etc. Have the conversations in stages, and as often as it can be worked into a normal conversation. That is, if your daughter talks about being with this boy, ask her what she thinks about the attention he gives her. Keep yourself calm, be friendly and matter-of-fact, and you'll have very valuable conversations with her.
From the boys' side, I have to say, having only sons, and knowing plenty of other parents with just boys, many (I'm not saying all) but many don't really think so much about their sons' sexual development. It's sort of a throwback to many years ago, as if it's more a problem for the girls and not for the boys. But boys go through all of the same feelings, and they have to be taught as well. If this boy does this again, calmly talk to him about it. For a 10 year old, I think it's just fine to say something along the lines of, "It looks like you are becoming very good friends with my daughter. And it seems that makes both of you very happy." Talk to him about what is appropriate and respectful behavior. That touching other people --- girlfriends --- event casually is very personal and is something for much more mature people -- teenagers.
I'm sorry... I'm rushing my response because I have to leave my house in 5 minutes, but I wanted to respond. The main idea is to be understanding, not threatening. Talk about what is going on. Basically, you want to really say, "You're too young to handle this sort of touching right now." But you know that if you said it that way, you've just fanned all sorts of flames!
Trust me. Boys spend lots and lots of time talking about this stuff with their friends. But they have to learn respect for themselves and the females in their lives. Otherwise, everything they do with girls becomes something of a competitive sport between them. It's the respect that we have to teach them very young.
I'm sorry this was rushed and a little off course. I hope you get my meaning. So yes... let them be together, but supervise and teach.