Legality and ethic of MUGEN

The engine itself entirely belongs to Elecbyte, so there's no question asked here. It's not nice to re host it without permission (not to mention it's completely useless), and hacking it and claiming it as your own is of course frowned upon.
Furthermore, the engine is free. If you find someone who is trying to sell it with any sort of content, it's illegal. And it's also a very bad idea, as it might catch the attention of companies like CAPCOM and SNK, who might get irritated at the entire MUGEN community.

Sprites are often ripped from commercial games. Big companies like Capcom and SNK have been contacted before on the matter of using these sprites in Mugen, and both have answered that they didn't mind as long as it was not for commercial use. There are records of the mails that have been exhanged on forums like Mugen Fighters Guild.
Other than that, there are some creators who actually make the sprites themselves. There are those who bring a more or less important amount of edits on sprites ripped from games, and there are those who draw the sprites themselves. Obviously, taking someone else's work and claiming it as yours is very, very heavily looked down upon. And don't even think that people won't notice.

The code is (usually) written entirely by the creator of the character (or stage, screenpack etc.) and this belongs to him and him only. This is legally true, although, for obvious reasons, you'll be hard pressed to find someone who would actually sue you for that.
As the code makes most of the work on a Mugen creation, it means absolutely nothing to claim that "Mugen creators steal from the companies anyway, so it's alright to steal from thieves !" Well, no, it's not alright, and you're not stealing from a thief, you're stealing from someone who worked for a long time on something he liked.
Of course, the term "stealing" does not look like it makes a lot of sense when talking about digital content. Afterall, if you download a bunch of Mugen files and use their content for your own and claim it as yours, what the original creator did is not going to lose anything, so "stealing" in the physical sense of the term is unfit. And yet, when you copy someone else's work and claim it as yours, you are claiming for yourself everything that goes with the release of anything : pride for your own hard work, respect from other people, and then there's the terrible insult of seeing your hard work being used and degraded and soiled by someone else's poor talent...
A matter of ego ? Maybe, but at the end of the day, you're still a douche if you're not nice to other people and don't respect their work. You may not care, but other people care, and no matter what excuse you try to use, the person with the wounded ego will never be worse than the person with zero civility. And anyway, it's useless to begin with, so that would also make you an idiot for not even obliging to most common courtesy, as it doesn't cost you anything. The question is, why would you even take someone else's work and claim it as yours ?

A number of people don't really like it when someone re hosts their creation on various sites. Of course, there's the pride in one's own work : you made it, so it damn well should be seen on your site and not someone else's. And no, it doesn't mean anything to act like it's selfish or a mark of bloated ego - why would you even want to host something on your site ? Afterall, it's already available at the original author's site. Isn't that greed for your own ego ? One other more practical reason would be that this version that got uploaded by some random guy could very well become obsolete the next day if the original author udates it on his main site. The only thing you get is multiple outdated versions of the characters, which is generally not really nice. If you only care about having as many characters for download on your precious site and don't care about the actual quality (a behavior usually referred to as "warehousing", and that's not a nice word in the Mugen community) you'll draw quite a lot of bad attention. And again, it's just useless. Honestly, it's that much simpler and less troublesome to just link to the site of the guy who made the creation to begin with.

Similarly, downloading a bunch of characters off the Internet, making a pack and dumping it on the Internet does not warrant being called "making a game". Most of the time, "character packs" are entirely useless, because they are way too punctual in time. It may be nice for a complete newcomer who has no idea where to look at, but quite frankly, there is zero upside to this compared to just giving a series of links to the websites where the characters can be found to begin with. And again, as with warehousing which I've just mentionned, you risk getting mostly outdated creations. This serves zero purpose, and all the reaction you will get from the community is getting verbally assaulted. You want to contribute to the community ? This is not how you do it. It's just so much simpler to give a list of links. Just downloading a bunch of characters and dumping them in a single zip is also in no way equivalent to making a game. Making a game in Mugen implies working on every single character so that they work well together, giving everyone a similar gameplay, similar effects, the same system... Making a game involves a lot of work.

Being productive in the community can have a lot of meanings. There are those who create characters and stages, but there also are those who help them create. Those people are just as helpful to the community ; it's always great to see people who care, and who give back to the community even if they don't have the time or knowledge to create a whole character. Giving feedbacks to help someone improve his creation is extremely appreciated in the community. This is a pretty simple and easy way to contribute not only to the creator, but also to the community as a whole. There is always a way to help each other out.
However, here again, there are a couple of things to keep in mind so that discussions don't get too heated. First, at the end of the day, creators do what they do the way they want it. They can listen to feedbacks and comments, or they can stick with what they chose to do. But this is not a reason for a creator to get angry at relevant feedback, either. For the sake of the community, simply aknowledging that a person is pointing out a mistake you might have done is generally the better course.
Those advices also apply for people who bring feedbacks. There can be feedbacks and comments on coding problems, and there can be feedbacks about gameplay choices. It may not be wise to try and force people to create things only the way you want. Knowing what you are talking about (about the code and/or about the game the character is based on) also matters a lot when giving feedbacks. Different people have different tastes, behaviors and habits, and if there is any feedback that really matters, it is about the quality of the code ; deliberate choices on the gameplay are secondary, as long as both sides can recognize and aknowledge what the other says.

The above is an assessment of what the community has been at some point of its history. Discussions have mostly been getting much more quiet in the last few years than they were before, which is excellent ; but let me still bring it up for the sake of not forgetting that everyone has limits to respect. Over the years, the community around Mugen has known disgraceful events and periods, usually because of issues related to respect - from both sides of the community. There are both creators and users in it, and aknowledging and respecting both sides is critical for the community to work.

The major guideline in the Mugen community is, quite simply, respect. A majority of creators will gladly let you use their work if you ask them, and won't say anything if you just credit the work you used from them. Just don't take someone else's hard work and claim that you made it yourself, because this will stick on your Internet buttcheeks for several years if you are unable to just admit your error.
It's just so much simpler and nicer to give credit where due. Because that's the way the community works.