If it were me, I would just run it as-is. I would have worried that the damag mushroomed the piston enough to contact the cylinder wall, but I see no scoring (especially in the darkend space on the cylinder wall above the first ring land).

As for cause of failure, who knows. All it takes is for that sealing ring to crack, or the head to loosen (or a combo of both) and it blowtorches it away to the next nearest location (in your case, the cooling jacket).

Don't forget to chase and clean out the holes for the head bolts before you put it back together.

Good Luck,
Michael