I think the problem is very general and very bad. Google doesn't make the displayed link match the actual URL in any way (like forcing the displayed link to be a prefix of the actual URL). I commented on this a while ago and I think it is very dangerous to web-surfers: http://www.win-vector.com/blog/2009/07/should-your-mom-use-g...
Summary: webmaster which is #1 in SERP is annoyed by traffic drops due to an AdWords ad that occasionally appears on top of him and might violate the ad guidelines (Google being unresponsive to his reports until now).
Besides a violation of the AdWords policies (landing URL impersonation) by the offending ad I couldn't find any loophole being described.
The loophole appears to be that the two domains don't have to match, with a twist that the eventual domain in the case was supposed to have been banned already.
My initial thoughts were that he was complaining about an ad killing his traffic, but it's really a plea for help because said advertiser is scamming the system after being caught. This off course presumes the validity of the OP story.