How can Google determine if a link is paid for or free?
They cant and that's the problem but they are looking for patterns and my guess they will be soon releasing the beast against paid links. The paid link report is probably just a quick and easy way for them to know who is buying links and then test whatever the big secret is.
I personally don't think they will be going after the very small link buyers or sellers but more of the ones who are basically link whores. There are people out there spending thousands per month buying links and others are making thousands selling them. Take
Col Crawford on Digital Point as an example, he has over 100 blogs where he sells links, articles etc and makes a killing from it. Google know very well about him and it would be very stupid if they didn't as he is well known within DP. Now all of a sudden he has announced that he is selling shop and has already had an offer of $80,000 for the network of blogs. Google probably see two problems with his network, first being with the abuse of the PR & back links but second Google is missing out on the selling action. Call the money reason a conspiracy but when you have a couple of hundred Col's then it makes sense.