No waterproofing and the one inch building gap

We are presently adding an extension onto our Park Slope row house, which includes the space that was our alley way. My understanding was that there is a law that requires a one inch gap between buildings. My contractor told me that this does not include the foundation wall, which he poured in concrete adjacent to our neighbors brick wall divided only with a thin sheet of plastic to mark the building line. The upper wall is concrete block and being flush with the in interior ten inch concrete wall leaves a two inch gap between the buildings starting about eight feet above the slab.

He failed to tarp the gap during the heavy rainstorm two weeks ago and my neighbors kitchen was flooded. (His intention was, that the two roofs would be connected and sealed.) However, we now have determined that the foundation walls were not waterproofed or set with any kind of drainage system. He considered the an “interior” wall since it is bounded by a roof on both sides…except for the gap.

My neighbor is furious at the contractor but so far not at us. He refuses to agree to attach the two houses at the roof line which would solve the problem. He wants, and I believe has the right to keep the two buildings discrete as opposed to capping over the now adjacent roofs. I proposed a backer rod to fill the gap set below the metal gutter he is proposing to collect and drain the water in an improvided gutter above the backer rod. While this would likely work, obviously covering the gap by attaching the two roof would be much more secure. His reasoning is that if he wants to build up his side of the gap then we would once again become vulnerable during construction.

What do I do here? The building is not complete. Should I insist that we tear down the walls and start again or is there some way we can waterproof from under? Or can anyone suggest a solution to this mess?