The only reason they disallow Flash is the same reason that they disallow any other "general-purpose application", which is that it can be used to do almost anything; the primary reason of having a computer in the good old days.
I'm surprised they even allow Javascript given what is possible with that, but given that the CPU in every iPhone and iTouch has specific hardware designed for Java acceleration, it is crazy that Apple refuse to allow Sun to enable that functionality in the software. And whilst I know Flash is mainly used for ads, being able to enable/disable it wouldn't be very easy to implement and if it was disabled by default, would make no difference to anyone except those visiting websites or pages that require Flash for a link to work (like some videos posted here which aren't on YouTube).
The standard iPhone is quite capable of running most normal Flash (you probably wouldn't want to though for battery life/CPU usage reasons), but it should be available as an option. As should an alternative browser like Opera. And emulators of old computer game systems (they all fall foul of the providing alternative programming rule).
Hell, even app developers who play by Apple's rules are bing rejected, which is why I am seriously considering jailbreaking to install those apps which the developers want to provide for free, but Apple doesn't want as it goes against their agenda.