Ultimately, the decision is up to the editor and in this case they disagree with your assessment. This is not uncommon -- sometimes the reviewer is wrong or it could simply be that the reviewer has high standards and this is a low-quality journal. It sounds like the editor thinks the authors should be given an opportunity to address your concerns, which is reasonable.
Is this normal? Yes. The editor makes the final decision and often deviates from the reviews (indeed reviews are rarely unanimous, so deviation from some reviews is necessary). The editor wants to send the authors more consistent reviews, in order to minimize author complaints. And if your review seems excessively harsh, the editor may want that toned down to spare the authors' feelings (they are human too).
Is this ethical? To some extent it's just necessary. Some reviews do need to be fixed. If you feel that it is going too far and you are being asked to lie, rather than just change the tone, then you can push back and explain why you disagree. If you really feel that your input is being ignored, then refuse to review for that journal again.
Any further thoughts? Editors might even edit the reviews themselves without consulting the reviewers, since that might be quicker and easier. However, I think that is a bit inappropriate and disrespectful to the reviewer.