it was a catch-up attempt at flash in the first place - they were very late to the game. i know people will say this is hindsight, but... silverlight wasn't around until 2007, and by 2009, when MS started pushing it hard, it was pretty apparent that flash/richui toolkits were on the way out.
silverlight shouldn't have been something they bothered with in the first place.
But it is a matter of hindsight. Microsoft was indeed very late to the game with Silverlight, but back then nobody knew that Flash was on it's way out. We knew that we hated full Flash websites but that's about it. Take a look at the following timeline.
2005 - Youtube was created. Adobe purchases Macromedia.
2006 - Kongregate was released. (Semi random example of a popular Flash gaming website.)
2007 - Microsoft releases Silverlight. Netflix starts streaming video online.
2008 - Hulu launches publicly
2010 - Apple releases the iPad, pushing Flash to the side. (Yes, the iPad was released just 3 years ago.)
And if we take into account the fact that Silverlight wasn't built in a day we could probably say that Microsoft started working on Silverlight before Youtube was born, during Flash's heyday, before HTML5 video was even an option, and half a decade before mobile devices started making Flash obsolete.
And let's not forget the fact that Silverlight is an extension of .NET and as a result it was a great competitor to technologies like Java Web Start.
Silverlight was dead on arrival because of the market penetration of Flash and it was killed a little later by tablets and by HTML5 and JS. But back then, for a short period of time, Silverlight made all of the sense in the world.
While I agree with your main point that the eventual failure of the browser plugin model wasn't as obvious in 2007 as it is now, I could pick different dates and show the opposite.
The video tag was invented in 2007, the same year the iPhone was released. Android followed in 2008, and it was becoming clear that the mobile web wouldn't play well with browser plugins. At the time, there was also a general trend to move away from proprietary standards (ODF was standardized in 2007), and it was obvious from the very beginning that Silverlight would be a closed-source, hard-to-reimplement, patented, Microsoft-supported-platforms-only thing.
In the end, it probably boiled down to developers not wanting Microsoft to gain control of the web ever again.
"a great competitor to technologies like Java Web Start."
Java Web Start was never widely adopted - trying to come up with a 'competitor' to that was stupid. Not even in hindsight - that was a stupid reason in 2007.
MS should be defining the future, not playing catch-up to out of date software. Their continued failure to do so is contributing to their decline in relevance.
I have thought for a while Microsoft would have been smart to latch on to Google's Native Client. .NET was something they did reluctantly to combat Java in the enterprise space: Their heart and soul has always been in native code (if you don't count the p-code in Office). And .NET has always produced native code out the back, anyway.
NaCl in Internet Explorer and later in mobile devices would have let them leverage much of their existing code base and developer tools, all with an "industry standard" imprimatur from Google. And where it wasn't supported (i.e., Firefox), you ship a plugin, which is no worse than Silverlight.
silverlight shouldn't have been something they bothered with in the first place.