I don't actually think refusing to sell materials containing photographs of child porn or other illegal materials that cause actual harm to actual people and/or animals is "censorship," personally, and I'm pretty sure the law agrees with me.

I do think it sounds like there's some backpedaling going on here and I'm not convinced Smashwords is all that devoted to free speech, but if all the Paypal policy is intended to do at this point is prohibit illegal materials and that's what's enforced, I'm 100% okay with that.