Here we have a distribution defined on test functions of two real variables (you can take ##C_0^{\infty}(\mathbb{R}^2)##, ##(x,y) \mapsto f(x,y)##).
Of course, ##[\delta(x)]^2##, meant as a distribution on ##C_0^{\infty}(\mathbb{R})## is an undefined expression, similar to ##1/0## in the algebra of a ring or field.
Such expressions of course occur often in physics, because we physicists are pretty sloppy, and then we have to think a bit deeper. A prominent example is to use plane-wave asymptotic initial and final states with S-matrix Elements ##S_{fi} \propto \delta^{(4)}(P_i-P_f)## and then calculation probabilities by taking ##|S_{fi}|^2##, which of course is an ill-defined meaningless expression. Then we "regularize" the expression and take a more careful limit to make sense of the ill-defined expressions. In this case it's simple, because one should know from classical electrodynamics and quantum mechanics that plane waves are not physically realizable descriptions of fields or states but indeed "distributions" living on the dual of the nuclear space of rigged Hilbert space. So the physical solution is obvious: You have to use true asymptotic free states, aka wave packets, and then also the scattering process being described makes sense.
Another example are infrared and collinear divergences when zero-mass fields ("particles") are involved. There the plane waves aren't even the correct "distribution-valued" (generalized) asymptotic free states, but rather "infraparticles" are. This is cured by either working with the correct asymptotic free "infraparticle" asymptotic free states (e.g., as Kulisch and Faddeev, or Kibble [*] worked out) or you do the more common approach of resumming "soft-photon ladders" (e.g., as detailed in Weinberg, QT of fields, vol. 1).
Last but not least the UV divergences in perturbative evaluation of S-matrix elements are dealed with in renormalization theory.
All this can also be formalized to avoid the mathematical night mares from the very beginning (see the above quoted book by Scharf).
Whether or not a complete mathmatically rigorous non-perturbative existence proof for any realistic QFT is possible, is not known yet.
[*]
P. Kulish and L. Faddeev, Asymptotic conditions and infrared
divergences in quantum electrodynamics, Theor. Math. Phys.
4, 745 (1970),
https://doi.org/10.1007/BF01066485.
T. W. B. Kibble, Coherent Soft-Photon States and Infrared
Divergences. I. Classical Currents, Jour. Math. Phys. 9, 315
(1968),
https://doi.org/10.1063/1.1664582.
T. W. B. Kibble, Coherent Soft-Photon States and Infrared
Divergences. II. Mass-Shell Singularities of Green’s Functions,
Phys. Rev. 173, 1527 (1968),
https://doi.org/10.1103/PhysRev.173.1527.
T. W. B. Kibble, Coherent Soft-Photon States and Infrared
Divergences. III. Asymptotic States and Reduction Formulas,
Phys. Rev. 174, 1882 (1968),
https://doi.org/10.1103/PhysRev.174.1882.
T. W. B. Kibble, Coherent Soft-Photon States and Infrared
Divergences. IV. The Scattering Operator, Phys. Rev. 175,
1624 (1968),
https://doi.org/10.1103/PhysRev.175.1624.