In the video, the anime says
Why don't you show me what the true power is, and defeat me with that.
I am wondering, is it possible to use it in place of that and still the sentence remaining grammatical?
Why don't you show me what the true power is, and defeat me with it.
Yes, you can replace that with it, and it will still be grammatical.
There are two possible reasons for the writer using that rather than it.
Firstly, that can be emphatic, whereas it is difficult to make it emphatic:
I don't want it. - unemphatic
I don't want that! - emphatic.
A famous example of the emphatic use of that is in Bill Clinton's statement:
I did not have sexual relations with that woman!
Secondly, it suggests that there is something else, a this.
I don't want this, I want that!