In 2008, Lisa and Anthony "A.J." Demaree took their three young daughters on a trip to San Diego. They returned home to Arizona and brought photos of their then 5, 4 and 1 1/2 year old daughters to a local Walmart in Peoria to be developed.

That should have been that, except instead of receiving 144 happy familial memories, Walmart employees reported the Demarees to the Peoria Police Department on the suspicion that they had taken pornographic images of their children. The police, in turn, called in the Arizona Child Protective Services Agency, and the couple lost custody of their daughters for over a month.

They were shocked. "Some of the photos are bathtime photos," Lisa Demaree told ABC News at the time, "but there are a few after the bath. Three of the girls are naked, lying on a towel with their arms around each other, and we thought it was so cute."

A Maricopa County Superior Court judge ruled that the photographs were not, in fact, pornographic, and a medical exam revealed no signs of sexual abuse. The girls were returned to their parents.

But the damage had been done: The couple's named went on a central registry of sex offenders, and "We've missed a year of our children's lives as far as memories go," Demaree told ABC News.

Image credit: ABC News

In 2009, the couple sued the city of Peoria and the State Attorney General's office for defamation. They also sued Walmart for failing to tell them that they had an "unsuitable print policy" and could turn over photos to law enforcement without the customer's knowledge.

A federal judge in Phoenix sided with Walmart, ruling that employees in Arizona cannot be held liable for reporting suspected child pornography. The Demarees appealed to the 9th Circuit Court of Appeals, and on March 6 the court held a hearing before three judges.

"The photos involved were simple childhood nudity," the family's lawyer, Richard Treon, told ABC News. He argued that Walmart committed fraud on its customers by not disclosing that employees would look at their photographs. Nor did customers know that employees could take photos they found offensive to their boss, who could then call the police.

"In order to convict a person of a crime of sexual exploitation of a child, you have to show that the intent of the photographer was to sexually stimulate the viewer. All the experts agree that even police officers don't have the authority to make that decision," said Treon. "So, we argued that Walmart was negligent in setting up this program with untrained clerks and giving them tremendous power over the lives of their customers."

Walmart did not respond to an interview request from ABC News. But, according to Courthouse News the company's lawyer, Lawrence Kasten, argued that under Arizona statute employees who report child abuse without malice are immune from prosecution. He added that there was no indication of malice in this case.

"I fear that what may happen after this case is [that the] employee will sit there and say, boy, if I turn these over my employer is going to spend millions of dollars in legal fees, and I'm going to get hauled in front of a deposition for eight hours, [so] maybe I'll just stick them back in the envelope and not worry about them," he said. "Immunity is supposed to prevent exactly that from happening."

It's unknown when the appeals court will rule on the case against the city and Walmart.