Can a state agency replace an American contract worker with an H-1B contract hire?

Technically, yes, they almost certainly did violate the law--and nothing will come of it. Almost every H1-B hire is a violation, except when you get to very rarified levels of education and training, when there are legitimately relatively few people in the entire world (let alone the U.S.) who have the requisite credentials: a few doctors, scientiests, researchers, engineers, and the like. Otherwise, almost every job filled by an H1-B worker could be filled by an American. Example: I used to work at a publishing company in NYC. They hired an H1-B art director, claiming they could not find an art director who could do book layout and cover desing in New York City--the heart of the publishing industry, and a city full of nationally and internationally known art and design schools. Clearly, this was false; they did anyway, because the woman they wanted to hire was good and worked cheap.
Companies and agencies typically get around this by crafting their job description (for purposes of the H1-B hire) to be perfectly aimed at that person's particular background. They do this after identifying whom they want to hire, rather than doing it first, then seeing who (including Americans) applies. 
The H1-B program has substantial support in government and society, across party lines and even among those otherwise in favor of restricting immigration; even Donald Trump's wife (Melania) first came here on an H1-B visa because apparently you cannot find an attractive woman or model in the United States. This example is offered to show how widespread H1-B abuse is: quite simply, whether you are pro-Trump or anti-Trump (so leaving politics out), it is very hard to argue that the U.S. needs to import models because we don't have people willing and qualified to be models domestically. If you can use H1-Bs for models and NYC art directors, you can use it for anyone. And despite the well-known abuses that have been happending for decades with the program, it goes on and action is almost never taken against the companies or agencies which abuse it.
So, yes: what you write about is a violation of the law. And if you try to make an issue of it, it is almost 100% certain that nothing will come of it but that you alienate people who may hire in the future and from whom you will probably want references at some point...that, and spend a great deal of your time and effort on a lost cause. This is not worth acting on.