Kurtz uses this example to show that the Vietnamese were so dedicated to their cause that they would mutilate children. Did violence at this scale ever happen? And was is used to prove an example to the Americans? Also, what was the extent of violence between the Viet Cong and the NVA against Vietnamese civilians?
The story itself is fictional, like very much else in Apocalypse Now. There has been some speculation that the story was inspired by atrocities occurring in the Congo Free State under King Leopold II, in which the book Heart of Darkness (which the film is based on) takes place. However, it's not entirely false in as much as it contains two elements of truth:
Special Forces units, throughout their commitment in South Vietnam, did provide medical care for South Vietnamese civilians.
There was selective violence used by the VC/NVA towards South Vietnamese civilians who supported the South Vietnamese government.
In guerrilla warfare, controlling the population and gaining their support is vital for the survival of the insurgency. It would be incorrect to claim that the VC never used terror to control villages or that the VC only used terror to control villages.
In some cases, the VC won the population over by making them politically aware, rallying them in political meetings and providing them with assistance beneficial to their village, like helping with the harvest for those whose sons had been conscripted by the ARVN. Violence and destruction caused by American, ARVN or other 'Free World' forces could also turn villages towards the VC. Some of this destruction could be provoked by the VC, using the motivation that by provoking them to attack an unarmed village then that would give them a propaganda coup and use that to show (and to radicalize the population) that the allies did not have a morally superior cause. To quote another South Vietnamese civilian: "The guerrillas always fired one or two shots to provoke the GVN, which brought bombers and artillery on the village, and then ran away letting the people bear the consequences."
But this wasn't always the case. Sometimes, it came down to fear and control through it. For example, targeted assassinations against individuals supporting or working for the South Vietnamese government could easily make a point and make other individuals fearful of speaking out against the VC or speak out in support of the South Vietnamese government. To quote a VC private in the Long An province: "It was the policy of the Front [Front National pour la Libération du Sud Viêt Nam] to destroy all Government organizations, and to destroy those who did not want to resign. They killed this man to make an example for others."
Interestingly enough, the use of terror tactics and violence against civilians was actually part of published VC doctrine; first being published in July 1969 as part of the the COSVN Resolution Number 9. Another oddity in the context of the Vietnam War is that the most infamous case of a VC atrocity did not take place in rural South Vietnam but in urban Hué during the Têt offensive. The Hué massacre, in which more than a 1000 individuals were killed, was like the previously mentioned assassinations targeting those loyal to the South Vietnamese government: Police officers and soldiers, but also individuals who held administrative posts. It is still difficult to get clear answers about what really did go down in Hué and the numbers killed are still in dispute. Nonetheless, the fact that a massacre did occur is established but it is worth considering that just like larger American atrocities, it was the exception rather than the norm.