Spoilers if you haven't played the mission Temptation yet. Putting this here since it's partial rules questions and partial mission report.

Under the Allure of Power mission event, the 2nd option reads, in part (to avoid providing spoiler fodder):

"Then, the Imperial player chooses 1 figure to perform 1 move and 1 attack."

I interpreted this R-A-W to mean that the Imperial figure can also choose Rebel figures, since it says any figure and normally all rules text for the Imperial player specifies "an Imperial figure". I also saw this as being thematic as the dark side being repelled by Diala's "inner strength" and latching on to one of her fellow heroes instead.

My rebel players were justifiably skeptical, but were convinced due to my experience with the game and thematic argument, so they just chose the other option instead since they really didn't want me to move one of their heroes out of position. When the mission event came up again later in the mission, they were forced to choose that option in order to not lose the game, but I opted to move my Dewback Rider into position instead to block a key hallway.

Also I want to make sure that I was correct in reading that the Rebels don't lose if all their heroes are wounded? I wounded all their heroes on round 4 but only able to take them down to 1 token and they were able to win before that turn ended (had to remind them to use Fenn's Weapons Expert to put the last point of damage through, so I consider it my personal victory still).

Not quite

There's a difference between "Choose a figure to perform attack" vs. "Perform an attack with that figure"

The 1st one is what happens in this mission, and Jabba, and Palpatine... where you can target that figure (Rebel in this case) but you do not control that figure. So yes you could select Diala but she'd whack your Imperial troops

The 2nd one is what happens with Murne and Embrace Suffering (HotE, Lure of dark side, 4xp card) where you actually get to "mind control" that figure and do whatever you wish

For the 2nd part correct, for this mission the Rebels lose when Diala withdraws OR has discarded all tokens. They don't lose when everyone's wounded

Ah, ok, I didn't realize this fell under that whole discussion but it totally makes sense now. I'm glad I didn't end up needing to shoot them with one of the heroes and the Rebels ended up winning.