The same server(s) also control the JavaScript code run by the client/browser. They could serve special code (to any one the government wanted to spy on) that returned their password to the server.
That's exactly why LavaBit shut down, looks like they were forced to do that.
right, but incoming and outgoing emails from lavabit servers won't necessarily be encrypted, unless the other party is using GPG or whatever - it's just the way they're stored.