Google won't be breaking the law either when they ask them to report some other stuff that might make a target out of you. I say it's moral for them to report on you when the time comes. You've got nothing to hide, amirite?
Moving on, what if blasphemy is illegal in another country and they (Google, Microsoft) spots someone who sent a a private message to someone else where they are making jokes about the prophet of Islam? What about countries ass-bent like India where you can't say anything bad about politicians? Will Google volunteer data about people who make bad jokes about politicians in private?
I know it sounds ridiculous but you're right. Where does the slippery slope end?
Problem is that on the other end... if they don't do this then they will have a PR nightmare. If people can spin their services as a safe haven for pedophiles, they will have a hard time.
I personally agree with this line of logic. I'm working on a personal solution for moving my data off the cloud. But, that isn't a substitute for having this discussion as a country. Until we draw lines that slippery slope exists and these things are legal.
EDIT: Regarding the safe-haven issue, I think that is a major issue with services like SpiderOak. They play up the ability to hide data. I personally believe we should be aiming for a solution that is closer to the locks on the doors of our homes. I feel secure at night, but I also know the police can knock it down by force if given a warrant. SpiderOak and other such services try to be more of a Fort Knox than a dead bolt. This is the cloud after all. Not a thumb drive in my safe in my home office.
Laws vary by country (Even if they are democratic for 50 year and more) and laws in some developing country appear stupid to any one in a developed country.
US has Freedom of Speech. India has exact opposite. You can get into trouble because no matter what you do, you will offend someone.
If they start reporting sedition and blasphemy, it'd mean that Google's ethics as a group has fundamentally changed, and we'd see far greater effects than their occasionally reporting someone.