Can we use adwords to drive traffic to website which has adsense ads and also runs few affiliate ads? Is this classified as arbitrage?
I think the answer to both questions is "yes" although I'm not sure that Google is completely happy with it.
Yes you can use adwords. But your site must have some content related to your adwords ads. That is the most important i think.
although they disallowed it, if you have enough content in your site, you should be fine... you can also use other sources to get more cheap traffic (yahoo, msn, adbrite etc.)
There was a post very recently about this, the guy in question spent $500 on adwords, while he made $550 dollars from adsense. A big investment i would think, worthwhile? Every one will have their own view on that.