How? (*Spoilers*)

I haven't watched it in a long time but my recollection is that they did have what he thought was sex. An old school trick of prostitutes and transsexuals etc. is to just hold the penis between their thighs and pretend it is actually inside. As to how convincing this is I don't know, but coupled with a bit of self-delusion and/or lack of sexual experience it might do the trick. Add on some convincing mumbo jumbo about Chinese modesty and you have a package that could pull the wool over the eyes of a man who, we must not forget, is smitten.

That's my take on it anyways.

http://www.nytimes.com/1993/08/15/magazine/the-true-story-of-m-butterfly-the-spy-who-fell-in-love-with-a-shadow.html?pagewanted=all&src=pm

"Then, as the examination is ending, the prisoner, without being asked, says that he would like to explain something to the doctors. Easily, smoothly, he pushes his testicles up into his body cavity. The skin of the scrotal sack hangs slack, like curtains. The man now pushes his penis between his legs, toward his back, bisecting the skin of the scrotum, and squeezes his legs tightly together. The penis is hidden, while the skin of the scrotum resembles the vaginal lips, beneath a triangle of pubic hair. Pushed between the empty scrotal sac, the penis has also created a small cavity so that shallow penetration is possible."