In general, be cautious about diagrams. In these cases, beware of
A change of topology, e.g. in flat projections of the Earth.
A change in metrics, e.g. the implicit metric on certain atlas projections vs the natural metric on a sphere.
In the diagram above, the topology is not a problem. Minkowski space, denoted $\mathbb{R}^{1,d}$, is topologically the same as $\mathbb{R}^{d+1}$, so drawing the diagram on a flat piece of paper is topologically OK.
The problem you have comes from point 2: when one draws a diagram on flat paper, one implicitly wants to use the standard Euclidean metric $g = dt^2 + dx^2$. But in special relativity, we must use the Minkowski metric $g = -dt^2 + dx^2$.
For example, a line segment from $(t_0,x_0)$ to $(t_1,x_1)$ in Minkowski space has length $-\Delta t^2 + \Delta x^2$. As we rotate a line that originally points in the $x$ direction to the $t$ direction decreases, its length - as measured by the Minkowski metric - decreases (even though the length is preserved by the Euclidean metric). As the line segment becomes vertical, its length even becomes negative. (Of course, in such cases this length cannot correspond with a physical length of an object.) Note that the Minkowski metric does not even preserve ordering of lengths relative to the Euclidean metric.
In your case, you will find that the physical length does contract if you account for the Minkowski metric, even though the Euclidean length increases.
Finally, note that we can't use standard trigonometry for triangle in the $(t,x)$-plane: the length of the hypotenuse of a right angle triangle with sides $\Delta x$ and $\Delta t$ is $\sqrt{-\Delta t^2 + \Delta x^2}$. However, if you use the hyperbolic $\sinh$ and $\cosh$ instead, you will find that you can mimic standard trigonometry in the $(t,x)$. plane (exercise). For example, $l = l' \cosh \alpha$ in your diagram.
I seem to remember a wonderful little book by Wald called Spacetime and Gravity (or something like that), which explains this well.