The Street Fighters are Robot Masters.
This answers pretty much all questions. Why are they attacking Mega Man? Why can Mega Man attack them? Why does he get weapons from them? Why do they explode rather than get knocked out (Which Mega Man can do)? Answer to all of the above: They're robots. If Street Fighter is the past of Mega Man, Dr. Wily might have used the Time Skimmer, last seen in Mega Man II, to go back and study the World Warriors in the hopes of defeating Mega Man with unpredictability instead of raw power. Dan (Man) was a defective model. As for why Wily is The Unfought, well, he might not have counted on how closely his creations mirrored M. Bison or Akuma. The Street Fighters aren't acting out of malice.
The game actually is another Street Fighter tournament and they invite Mega Man to have a friendly anniversary match. Since the game is from Rock's POV, we see all the long way of reaching the world warriors around the globe (while other SF games cut to the tournament fight itself). The explosions are mere Gameplay and Story Segregation (as Fatalities in Mortal Kombat, since all Kombatants survived the first tournament), while Mega Man getting the weapons of organic fighters has precedent in his MvC1 ending.There will be a sequel sometime in the future, perhaps to commemorate the series' 30th anniversary.
Naturally, there will be a different set of Street Fighter characters to challenge, hopefully far more representative of the entire series than the first game was. One of these will obviously be Ken, since you have a Shoto quota to fill. Plus, obtaining the Shoryuken from him would be a nice nod to Mega Man X2. Another may be Dee Jay, if only because his theme and Gemini Man's go together perfectly.Gill would probably make for the best Final Boss candidate given his powers (and since Bison was Shun Goku Satsu'd by Akuma), but I get the feeling we'd more likely be seeing the far less imaginative and far less liked Seth. Oh, and Oni will probably be there as the new True Final Boss since, as Akuma 2.0, he thus must be inserted into nearly everything like Akuma is. The other option would be to have Akuma show up again, but then be escorted off-stage by Gouken.
Balrog killing Mega Man in one hit is a subtle nod to Punch-Out!!
Balrog, named M. Bison in the Japanese Street Fighter, is based on Mike Tyson — obviously changed because laws in the states regarding use of likeness are a bit more complicated than can be solved changing one letter. Another 1987 game, Punch-Out!!, starred Mike Tyson who was notorious for often being able to one shot the player — especially early on. Put the two together, factor in it being a fan game based on the 80's and early 90's, and you have a stealth tribute.