I found this story interesting and a little disturbing.

http://www.cnn.com/2007/TECH/fun.games/06/09/sony.manchester.ap/index.html

Should there be any limits on what settings can be used in video games? Is it acceptable to use a cathedral as a setting for a battle?

In general I disapprove of censorship, and think that all ideas ought to be able to be expressed. I also think that if something offends you, you should not listen. I fail to see that this injures the church in any material way, although it certainly does go against the message of the church in supporting peace. I would find the use in poor taste, but I don't think it is legally unacceptable to display poor taste.

The one concern I have, although I think it a minor risk, is that someone might think it a good idea to recreate the game IRL in the cathedral.

Seriously, when has anything like this been an issue? Many a video game has used religion and churches as backdrops, all the violence included. Why should it be a problem now?

Every WW2 game I've ever played has had some battle in or around a church or cathedral. In Medal of Honor the Germans were holed up in there, you had to get to the church via the cemetary.
Frankly, I'd rather see incredibly offensive stuff then the shit we're given in Call of Juarez where if you kill innocent people or animals you imediately lose the game. How the fuck is that immersive? I blame it on Germany. If people are talking about how a game should be banned, chances are Germany did it before it was released.

The one concern I have, although I think it a minor risk, is that someone might think it a good idea to recreate the game IRL in the cathedral.
That possibility is completely unsupported by any study. No study has conclusively shown that games make people more prone to violence. It is incredibly rare for ANY media to be replicated in real life, books or movies or whatever. That situation is exclusive to the media itself. There has still yet to be an argument against D&D that is actually supported. Games and media have never been shown to be the cause, only the excuse after the fact.