I can't wrap my brain around what it would mean for a particular BitCoin to be illegal. This also seems particularly illogical as it punishes only innocent people -- the criminals will launder the BitCoins long before accounts can be added to the government's list.

Its possible but:

1. The USA government is not the government of the world.
2. It would be really hard to make people check the bitcoins they get. It would be basically unenforceable.

Upload them to and exchange.

What happens when you receive a fraction of  a bitcoin? Does each coin have a guid, ahdn if I receive .5 of coin "A", does my wallet literraly track that I have 1/2 ownership of coin "A"? And this works all the way down to eight decimal places?

For any value in the system, that value has an origin point and a chain of custody. You don't really get .5 of any particular coin. If I mined 50 bitcoins and want to send .5 BTC to you, what I do is form a transaction that works like this:

1) It imports the 50 bitcoins I mined.
2) It exports .5 BTC to you.
3) It exports 49.5 BTC to me.

I certify the transaction by signing it with the private key that corresponds to the public key specified when I mined the original 50 BTC.

Transactions work by importing bitcoins in from one or more sources and exporting bitcoins out to one or more sources.

Your .5 BTC isn't really half of any particular bitcoin. It can be tracked back to its origin(s) but so can any.

For example, I could just as well have imported in 50 bitcoins I mined and 35 bitcoins I got from someone else, exported .5 BTC to you and the remaining 84.5 BTC to someplace else. It is meaningless to ask whether your .5 BTC came from the 50 I mined or the 35 I got from someone else.

And whatever choice you make, you don't hurt the person who you need to hurt -- the person who sold drugs or the person who bought them. By the time you could do something, it's too late to hurt anyone but innocent people.

I guess I would  have to launder my bitcoins. 

The receiver has an obligation to check the validity of the bill because they *can* check the validity of the bill. If I receive bitcoins from you, there is no way I can check whether you gained them illegally or not unless they're already on some kind of list. In every realistic case, the illegality of the source will never be discovered until after the bitcoins have been transferred. It is not at all analogous to counterfeit currency to hold the recipient responsible for not checking something he could not have checked.

We treat a possessor of counterfeit currency as not innocent because he could have discovered through reasonable effort that the currency was not valid and because the currency was never valid. Invalidating currency after it has been transferred is much different.

A better analogy would be the government taking a $20 bill from you that you could prove you got from an ATM machine because the serial number was recorded as having been used by someone 800 miles away to buy drugs two months ago.