I'd rule that the dagger works if it's on his person.
If someone thinks rules lawyering is the act of trying to get out of your stuff what you really thought it did, then this guy rules lawyered and I don't see the problem with that. I consider rules lawyering to be finding loopholes in the rules for the sake of exploiting them, and I'm all about thinking that's a bad idea, so I'd house rules it away. In this case, it sounds like he kept the dagger because this is what he thought it did, so I don't have a problem with it.
Faerun is a powerful, powerful place, so I don't see the problem with this specific item.
Finally, as far as the game is concerned, whatever the GM rules is law. If he rules in a way that you don't want to accept, then discuss it with him, but in the end it's his judgement call. If he rules in ways you don't like a lot, then quitting is better than dealing with it. But every player should keep in mind that in order to find a GM that'll give them their way every time they'll have a long search in front of them.