Killing Osai would have gone against everything that was Aang! This was obviously going to be a struggle for him when the time came. It was smart to have the Avatar State take over and make it less obvious how things were going to turn out.
It was hard to understand what the Lion-Turtle was saying exactly, but I did get the impression that the Bending removal procedure had risks and that Aang decided to take the risk, rather than take the easy way out and kill Osai. Having him loose his own bending abilities as a consequence might have been a good idea though, and it seems like something Aang would have been willing to do under the circumstances, and it would have made more sense, since he was all about putting himself at risk over others. My impression of what the Bending removal thing failing, was that he would have turned evil, therefore putting everyone else at risk. (Not typical of Aang). However, loosing his bending abilities would have trashed chances for the obligatory mini-series or sequel.
All in all, I was very satisfied that they gave us an ending that made sense, and gave us closure on the main storyline, rather than just pull the plug as they do with most shows.