Two boys aged five and seven were removed from school and quizzed by police over their toy guns, leaving them terrified.
The children were at their school in Befordshire last year when they revealed their parents had bought them the bright green and orange toy guns.
The school then told police, who subsequently questioned the boys over the toys.
This has left a psychological impact on the children according to their mother, with both having nightmares, the BBC reported.
The local council has now said they were discriminated against and Central Bedfordshire Council will pay an undisclosed sum to the family in compensation.
At the time of the incident the woman was told that one of her sons had been talking in Arabic and spoke about going to a mosque, but she has claimed they don't speak Arabic, nor do they attend mosques.
She said: "They [the school] had no other reason to believe they had any signs of extremism other than the colour of their skin.
"I understand that [terrorism] is a problem, but this is a rather blunt instrument with which to tackle it."
The mother also added that her family's reputation "had been trashed." The two boys have now been moved to another primary school.