How exactly does it work? Does it just prevent enemy squadrons from tarheting and attacking adjacent non escort friendlies? Or can enemies still choose to attack non escorts but will activate an attack from the adjacent escort?

I'd say the word "cannot" makes it rather clear.

EDIT: But yeah, option A: If you are engaged with a squadron with Escort, you can't attack anyone else.

...unless they also have Escort.

...or you are performing a Counter attack.

The former. A Tie fighter cannot attack a wounded B-Wing if the Tie is also engaged with an X-Wing. The TIE must either shoot the X wing (or any other escort squadron in range) or not attack at all.