Here's my proposed solution to the battle:

-The elven attacks still happens, though they would have won a Pyrrhic victory, losing >2/3 of their fleet

-Hammerfell was able to retreat with 50 of their ships back to mainland Hammerfell, they are also allowed a smaller reserve fleet around Sentinel

-The locals of Stros M'kai can either continue fighting, putting higher casualties on the invaders. Or, they can hide and start a guerrilla campaign that has more long term effects than short term.
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Alternatively, we could just have everyone dead and everything destroyed.