I'm not sure that's really the crux of the matter, but it is a social encounter until the combat starts. You might have ruled differently.Why would the DM let it get out of hand like that? I made the ruling that he went first. If he was using sleight of hand to hide it, it would be sleight of hand and not deception which is purely social. End of story. If the players want to have a discussion about it after the game, they are welcome to, but disruptions like that should not be tolerated.
"Sleight of Hand. Whenever you attempt an act of legerdemain or manual trickery, such as planting something on someone else or concealing an object on your person,"
The DM in this case ruled that since the dagger couldn't be concealed in Player 1's hand (the dagger is too big / hand too small) he wasn't concealing it on his person. He was either trying to draw attention away from the dagger in his hand, or draw attention away from the fact one hand was holding something out of sight (up his sleeve, alongside his leg, behind his back or something), hence the Deception check.
Again, you might have ruled differently, but probably not since we know you prefer that the situations to make sense, and concealing a dagger in your hand doesn't make sense.
If you, as the DM, have made a ruling that Player 1 goes first, because he is throwing the dagger, would you then refuse to listen to arguments from Player 2 and Player 3 that their intended actions were equally as quick? (There's a reason why the characters involved are all PCs, not NPCs.)