Privacy in 2 story home overlooking a neighbors backyard

Let me try to answer your last question first. Generally speaking, a person does NOT have complete privacy in their backyard, when things that they are doing may spill over out of their backyard. (Eg., pot smoke, loud drunken parties, etc.). If your neighbor does not want to be seen, he/she should conduct their "inappropriate activities" inside with THEIR blinds shut. You cannot and should not have to avert your eyes from a public spectacle. Now, on the other hand, if someone is deliberately spying on them with binoculars, video taping them, etc., the result may be different. As to your second question, can your neighbor call the police for this? Yes. Anybody can call the police for anything, at any time. Just calling the police does not mean that a crime has been committed, or that the police will investigate anything. I would ignore his attempts to intimidate you. Hopefully the police have better judgment and better things to waste their time on.