Any change in average processing volume and ticket size is a red flag at any payment processor. An individual/business suddenly getting a ton of "donations" is going to look suspicous. An individual/business that hasn't told their processor their plans, and gets a ton of "donations", is going to have to convince that processor the donations are really donations and are going to end up going towards what they said they'd go towards -- because if they don't, all those donors may charge back the payments, the fundraiser may disappear, and the processor is on the hook for all the costs.
OP's situation is pretty weird. If that conversation actually occurred, it wasn't handled well at all, and PayPal may well have done a lot wrong here. That doesn't mean it wasn't a high risk situation when PayPal initially froze the account to stop it from getting riskier.
I also think the OP's wrong about losing fees on everything twice even though the payments were refunded. When you refund something through PayPal, PayPal refunds its fees to you, even if it was a credit card transaction.
The problem didn't seem to be that the volume/value of transactions suddenly went up. The Paypal representative didn't say that at any point in the conversation.
Even if that was indeed the case, a simple investigation of the issue would have cleared things up. Businesses are supposed to work with customers, not fuck them over at the first sign of trouble.
I am sorry, how are you privy to the conversation? Or are you just looking at the bits posted on the blog? There is no way you can draw such a conclusion form that.
I hate to come down on the side of Paypal, but it would be so easy to abuse the donation button by doing exactly this, and not sending out any gifts. There is no way paypal can test this.
The official policy is actually that the "fixed fee" ($0.30) is kept, and the "variable fee" (2.9%) is returned to you, but in practice in many situations the fees are fully refunded. The situation is somewhat different for micropayment transactions (which are 5% + $0.05), but this vendor was probably not using them for this account (in most situations, unfortunately, this is an "all or nothing" account flag).
(I actually spent a half hour talking to my PayPal account manager today about this very subject, presenting different charges and asking why fees were or were not kept in various situations; however, I do use micropayments, so my results are not going to be terribly relevant, and we are actually continuing the conversation tomorrow. ;P)
OP's situation is pretty weird. If that conversation actually occurred, it wasn't handled well at all, and PayPal may well have done a lot wrong here. That doesn't mean it wasn't a high risk situation when PayPal initially froze the account to stop it from getting riskier.
I also think the OP's wrong about losing fees on everything twice even though the payments were refunded. When you refund something through PayPal, PayPal refunds its fees to you, even if it was a credit card transaction.