Short-selling in India was always possible (and actively engaged in by all types of investors - from FIIs to the individual small investor) via the futures market. Allowing shorting will increase the overall liquidity available to parties wanting to short a stock - liquidity will now be the sum of cash and futures volume as opposed to just cash futures volume. Further, for the stock where the futures are not active, it will be possible to short the cash market.
Now, the reasons why the FIIs shorted by borrowing stocks instead of the futures markets are:
1) They borrow and short stocks for which futures do not exist (e.g. Educomp)
2) It was much cheaper for them to short by borrowing as opposed to shorting the futures because of the cost involved. The cost of borrowing stocks, according to reliable industry sources, is approximately 4% annualized. The margin requirements on stock futures vary from 25-50% of the contract value depending on individual stock volatility.
3) In India, for both stock and index futures, liquidity exists only for the future contract expiring at the next earliest expiry (near month futures). The liquidity in longer-term future contracts (extending from 2 to 3 months ) is very low.
In any case, the impact on the Indian markets of FII short selling in the cash market is over-rated since the overall volume is low compared to the traded volumes and one shouldnt read too much into it from a trading perspective.