First off, my reaction: Kudos to China for being efficient. They want to break the spirits of their prisoners and they've found a way to do it that is not only inexpensive, but turns them a profit. Can you imagine what would happen if the U.S. co-opted this punishment? Forget license plates, we could probably get the prison system to pay for itself. /deadpan
Next, some explanation: Folks, forget for one moment that China is jailing people for the wrong reasons. This happens everywhere. Governments take those that defy them and place them in small rooms with bars on the windows or little pine boxes. Every continent, every nation, does this. They just do it in different ways and on different scales. China is not special in that regard; They are just one of the bigger players that gets more press.
China is special in the regard that citizens of China cannot purchase subscriptions to WOW. They can buy prepaid cards that give them time on WOW servers, but not an actual subscription, and the bulk of the gaming that is done in China is done in Internet cafes because most Chinese citizens cannot afford to buy a computer, much less Internet access. That means that players are not bound by a set IP address, since they can play anywhere a card is accepted. If Blizzard were to ban an IP address to stop gold farming, it would take out not only the farmers but also any legitimate players who used that address. Given that Blizzard is a business and the first rule of any business is not to go bankrupt, I think Blizzard would rather take the money of both farmers and players than deny both the opportunity to pay. China may not be the biggest fish in the WOW pool but it's big enough that if it went away, Blizzard would feel the financial pinch.
Finally, an observation: The purpose of a prison is to punish the occupants, to break the spirits of those who broke the law. Forcing someone to perform a tedious task until they collapse is a form of punishment and grinding in an MMO is nothing if not tedious. Does it anger me that something I see as a source of entertainment gets perverted into a form of torture? Yes. I'm also angry that someone is profiting off of torture, quite handsomely if the estimate of the size of the gold farming market is even remotely close. But if you're going to rule the world, and believe me China wants to, you can't just control the legal. You have to control the illegal too. If you don't, someone else will and that someone else might decide one fine day that, since it has the whole illegal thing down pat, it might as well take the legal part too.