When you say "Amazon and Walmart also have X% disallowed knife ads, but X is an extremely small percent of their overall number of items. Accounts remain active." the implication is that total ad spend vs banned ad ratio prevails. That would suggest that the knife guys could start advertising flowers, buy 90% of their AdWords for their buddy the florist and only 10% of their AdWords for their knives and be Okay. I don't think it would work out.
Google is just acting poorly here, why doesn't matter. As the original poster points out, 'assisted open' knives are legal for sale in the US (even in California which is kind of picky about such things). They aren't part of the terms of service explicitly, so either they are or they aren't. And if they are, they are for everybody, and if they aren't they are aren't for everybody.
I'm sure if .01% of WalMart's ad spend was for Canadian pharmaceuticals that they would be shut down in a heartbeat (because the Government really came down hard on Google for that).
Its common knowledge that one of the ways larger successful sellers on Ebay harass smaller sellers is by reporting them for various rules violations. When a "Power Seller" has a dedicates account manager inside Ebay they don't have to put up with random reports like the small guy who randomly gets someone in the problem reporting staff. That asymmetry is exploited to mitigate small seller effectiveness. I have no idea if this goes on in "AdWord" competitors but some of the lawsuits I've read from various people (especially on contested keywords) suggests the advertisers (or their agencies) aren't above such tactics.