The "physical signs" are not signs of sexual arousal, just arousal... a spontaneous erection can happen any time nitric oxide is elevated, which can happen during anything exciting (this is why men in combat sometimes get erections). Erections can also happen during sleep in response to a full bladder (the erection serves to prevent urination.)
Nitric oxide is a vasodilator; it causes muscles to relax.
Erections are controlled by smooth muscle tension preventing the full flow of blood into the penis - when the smooth muscle relaxes, blood flows in quickly. During REM sleep, the body enters a self-inhibitory state such that the body does not respond to what the brain is imagining (otherwise, we'd all be sleep walking); this extreme relaxation may relax the smooth muscle and result in a completely non-sexual arousal.
(Of course, this doesn't preclude the brain sensing the arousal, and then taking that as a trigger to change the subject of the dreaming.)