Google's Webmaster Help Center explains Google's policy on paid links and encourages people to report them to Google. Here's a snippet from Google's statement:
"Buying or selling links that pass PageRank is in violation of Google's webmaster guidelines and can negatively impact a site's ranking in search results.
Not all paid links violate our guidelines. Buying and selling links is a normal part of the economy of the web when done for advertising purposes, and not for manipulation of search results. Links purchased for advertising should be designated as such."
Google essentially want websites to designate paid links with rel="nofollow" anchor tags, so link juice or PageRank is not passed on to the website who bought the link. The use of rel="nofollow" anchor tag was originally conceived to stop comment SPAM on blogs and discussion boards, but its use has now spread to the policing of paid links.
I understand the difficulties Google and the other search engines must have in determining when to pass link juice between websites, but leaving the webmaster in control of this is like asking Google to start ranking sites by meta keywords again.
I'm beginning to believe the future of web search lies in the democratic nature of the StumbleUpon, Digg and other social bookmarking methods like (del.icio.us and my favourite ma.gnolia), whereby users vote, tag and bookmark sites. Surely a combination of popularity and search algorithm is the way forward?
Updated: Shortly after I posted this blog entry, Google has been spotted testing Digg-style voting buttons on their results pages!
Updated: Matt Cutts and Maile Ohye posted on The Official Google Webmaster Central blog on 1 Dec 2007 a post that intends to clarify Google's stance on paid links.