yes, google can track your bank account, your paypal account, your moneybooker account, and can even smell the money under your pillow
OK a serious answer to your question, Google can look at the links on your page and attempt to identify certain patterns, so for example if you have a block of links, all together, linking off to totally unrelated sites, then that can look suspicious and could be a sure sign of paid links. This is why it is important to make any links on your site look as natural as possible.
robuk21 - from that you said- it seems that paid linking to related sites is not too suspicious for google
I believe, they have some sort of system to track the paid links. they also have a system where you can report the people who buy/sell links.
When you have a sidebar block titled "Sponsored links" and a bunch of links underneath or something similar in the footer as well as a link called "Your link here?" or "Buy links" which leads to a page with all the price plans then you will get spanked. Just use common sense.
I don't know how can do that, but as mightyb said you need to be careful to not look to suspicious with such a things.
That is manually managed i think , you can submit the information about link selling to google from panel of Webmasters Tools, and think many people using this. Think they haven`t any automated solutions, but anyway if someone put`s info directly on the site he sells links it is much higher risk to find by them automaticaly.
Bigger problem is companies that do SEO which have their own exclusive directories. You sign up with web design company. They offer SEO as addition to their package. If you agree and pay high fees, they include you in a few 100 directories with only their clients. No obvious note that they are paid links.
That about sums it up. Gettng 'dobbed in it' by a competitor is the obvious route to get a googlespank for link buying.
Google does not know. Even though your link is in a "Sponsored Links" list does not necessarily mean that it is a paid link. Usually what happens is they get notifications from users through their webmaster tools section and work through these notifications manually if they indeed find indications on the site that these links are bought/sold.
In google webmaster tools, there is a link "report paid link" . That is easy for your competitor to report your paid links to google .