1. Can he kneel Direwolf Pup and Greatjohn Umber to trigger the event? We ruled yes, as the Stealth means they can't be declared as defenders, not knelt for a card effect.
Yes. Stealth only keeps them from being declared as attackers.
2. Does he still have to defend the challenge? We ruled no, based on the explanation from the rulebook: before and between (but not during) each phase there are opportunities for card play. He therefore could play the card right after I announced my attackers. Since they were all killed, it seemed logical to say that there was no longer any challenge. Or, it also seems possible to say that he must still defend the challenge with at least 1 STR or else lose as ties go to the attacker (and attacker STR=0). Any insight into this particular issue which I am sure comes up more often?
No. Attack strength of zero is essentially no attack. It's just like effects that reduce defense strength/s to zero; there is no defense at that point.