kreynolds said:
I could create a whole new family of magical traps using that idea.

Seriously, I'd rule that the necklace just falls from the neck as it turns into a ring. Seems really lame that a 56th level fighter with a strength that rivals the Tarrasque would have his head pinched off by a ring of freedom of movement.
The SRD beat you to it Kreynolds.
Necklace of Strangulation
A necklace of strangulation appears to be a rare and wondrous piece of valuable jewelry and, short of the use of something as powerful as a miracle or a wish, can only be identified as a cursed item when placed around a character’s neck. The necklace immediately constricts, inflicting 6 points of strangulation damage per round. It cannot be removed by any means short of a limited wish, wish, or miracle and remains clasped around the victim’s throat even after his death. Only when he has decayed to a dry skeleton (after approximately one month) does it loosen, ready for another victim.
Caster Level: 18th; Prerequisites: Create Wondrous Item, slay living; Market Price: 60,000 gp.
The only difference is the PAO necklace requires a dispel magic or antimagic field to work and might cost less to create.
alternatively from the reduce spell
A shrinking object may damage weaker materials affixed to it, but a reduced object shrinks only as long as the object itself is not damaged.
So maybe it will pass through the flesh but be stopped at the hard bone of the vertebrae?
And for reference for the original question from the srd:
A magic item or weapon or other object can be polymorphed into another type of magic object, but it never gains abilities superior to those of the original object.
So I think +3 dagger into +3 great sword is fine, but turning it keen is not something the spell can do.