Flat-footed however, is a matter of having PREPARED for combat. Just because two people are arguing or highly suspicious of each others motivations doesn't mean EITHER of them is actually in a combat stance of some sort and ready for any potential attack.
This, and your example, are a good way of putting it, I think, saying, in a different way, what some of the posters above has said.
Now suppose one of them declares that he draws a weapon and DOESN'T attack? Well, if the opponent draws a weapon in turn THEN it can be argued that neither of them is flat-footed.
This is an interesting example.
Let's say your in a game. The PCs are in the local tavern. For color, you've been describing some loud mouths sitting at a table not far away.
One of them gets up to go to the head and he bumps into the PCs' table. "Hey, you maggots, " he says to the player characters, "stay out of my way, or I'll piss on you."
The players take up the challenge. The fighter in the party stands, looks the NPC straight in the eye, and says, "Well, whip it out then, and try pissing on me."
The other PCs stand up and give their comrad room with the jerk.
Now, the DM has an impromptu role playing momen on his hands that can easily degrade into a fight.
The NPC smiles a toothy grin at the fighter, takes a step closer to him, and jabs his finger into the fighter's chest, "You look like a toilet to m...."
"That it!" The player interjects. "My fighter hits him, right in mid-speech. I'm rolling my attack!"
Now, some DM would roll initiative here, and some would automatically give nish to the fighter.
Either way, one of them is going to be flat-footed.
Where one DM would give the fighter automatic nish, based on the encounter, and aother DM would think that the NPC was expecting the fight and should have a chance to act first, therefore rolling nish normally between the two, I'd go ahead and roll nish but give the PC Fighter a +2 circumstance bonus on the throw.
But, how you handle it doesn't really matter--unless you automatically rule that neither is flat-footed.
I don't really think that should be the case, and I'd stick to RAW.
If the player STATES, "I prepare to defend myself against his sudden attack, but don't actually draw my weapon," then the DM could decide that he's not actually flat-footed for the next round, say.
Here, too, I'd give the player a circumstance bonus (probably +2) on his nish throw but not automatically make him not flat-footed.