So I did some research into the sources and found that the commonly sourced Gazetteer article sources it's claim to a book called The English in Western India by Phillip Anderson. It seems that the Portuguese were warring with the Marathas and the British thought that the Portuguese ship was a Pirate ship, so they intervened. Due to this action the Portuguese and Brits had a minor back and forth scuffle. At the Apex of this misunderstanding the Portuguese assembled their entire South Asian fleet at Salsette near their Fort in Versova awaiting a navel battle with the British. During this action an unknown Arab fleet managed to surprise the Portuguese, burn their ships, and kill everyone in the Fort at Versona. Not the village. Not local Indians. But Portuguese garrisoned at their fort. The Portuguese and Arabs skirmished until they got reports that the British were coming and the Arabs fled. This event then caused the Portuguese to sign a treaty with the Brits making them allys in South Asia.

So here are my problems with this story. First of all by 1694 the British and Portuguese not only signed many treaties, but King Charles the 2nd married the royal heir Catherine of Portugal. All though minor skirmishes still occurred something of this scale would have been called off. This sounds like something either made up or exaggerated by the British to show how weak the Portuguese were. But that's just an opinion.

Bombay: The Cities Within by Mahotra and Dwivedi do have an extensive history of Indo-Arab trade networks that flourished at this time in bombays history. With trading going on with Muscat, so it could be possible that that's where this rumor started.