Paladins have been barred from having evil associates. "We are judged by the company we keep", and he certainly should not condone evil or chaotic activity.
But is this another example of simplistic morality? What is more noble, to shun those who turn away from the path of righteousness, or to stand as a shining example of righteousness, showing the unenlightened the error of their ways, and working to redeem them? "Love the sinner, hate the sin"
Not necessarily. While the original restriction was almost certainly intended to be a simple gamist construct that restricted the ‘moves’ you could make in game, the underlying issue isn’t simple at all.
It’s actually a minority of real world religions that would agree with the assumptions you raise. That it seems simplistic is a background bias, because the actual issues here are quite complex and there is very little agreement on them. Some religions make a distinction between being with or among the impure - heretics, nonbelievers, sinners, low caste, however that is defined within the religion – and being associated with them. That is, a religion might command its followers to be friendly to the out group, it might forbid that they should ever be connected to them. Perhaps you can fellowship with them, but you can’t be their associates. Love your neighbor, but do not be yoked to them.
But in the vast majority of religions, whether Eastern or Western, even to be among the impure is considered wrong. These religions focus on the idea of ritual or spiritual purity, and the outgroup – heretics, nonbelievers, sinners, low caste, heathens, etc. – caries the idea of uncleanliness so that even to touch them or to be among them contaminates you and renders you unclean. Just as a sacred space has to be set apart from mundane uses in order to be a sacred space, in order to retrain your sacredness, you have to be set apart. This is the reason for example that if you clown around and blow bubbles in Arlington National Cemetery and particularly around the tomb of the unknown soldier, someone from the military is likely to point a bayonet at your throat and ask you to leave. They wish to protect and keep the place sacred. Likewise, the vast majority of world religions keep their priesthood set apart as a special caste of persons so that they will retain their purity, and require the followers of the religion to be set apart.
So one major question is how associated can you be with the outgroup and still retain your purity? Most religions absolutely forbid marrying outside of the religion, but after that it gets more open to interpretation. Can you form a business partnership? Can you be friends? Can you eat a meal with them? How connected in the mind of an onlooker are you allowed to be? The religion I imagine you are most familiar with is actually really unusual in allowing and even encouraging this sort of fellowship with the outgroup. Most would answer the question, “Should you eat a meal with them?” with “Certainly not! Forbid that I should ever be seen with sinners or heathens!” There is even a widespread extant religion where the mainstream widely accepted jurisprudence regarding the religions demands is that to form a friendship with a non-believer is a crime worthy of death, and the only valid excuse you have is if you are just pretending to be friends because you feared for your life if you didn’t.
At some level, we are going to have to define ‘good’ if we are to proceed here, and that’s an even trickier subject than evil. We can usually agree at a high level on what is evil, but what is good – what is the remedy to evil – is not something that there is usually agreement on. Everything about your post reeks with viewpoint. Many religions don’t believe that people are redeemable, and some even believe it is wrong to even try. Many religions believe that people are destined to certain outcomes, and attempting to effect that destiny – even to a positive outcome – is wrong. In a D&D context, lawful religions are more likely I would think to believe in destiny, and the more lawful the more likely that they are to believe in unchangeable destiny. And it’s not like only good fantasy sects might expect their priesthood or followers to be set apart in some way so that they could accumulate sacred (or profane) power.
So I think it is reasonable that some lawful good fantasy sects would demand their most sacred mortal representatives to always be set apart from the unclean and not associated with them. Also some sects might believe that mercy is good because it is good for you to be merciful, or because it is good for those that receive it. That is a pretty big distinction. To pick on a real world religion in a way I both hope won’t offend anyone and also won't promote piling it on or venting, do you think the street preachers that shout on soap boxes do so because they think it is good for the souls of those that hear them, or because they think it is good for their own? In other words, is the act motivated by empathy or is it motivated by the desire to be more set apart and more sacred? Is it motivated by the desire to win converts and assimilate the hearers (even if or because you despise them), or is it motivated by a desire for self-improvement? In D&D terms, exactly what is going on to motivate that act could be the difference between law and chaos.
Even within the very few religions that promote charity toward the outgroup, there is usually historical tension between the desirability of being cloistered away in a sacred place to pray and worship and the desirability of reaching out in acts of charity. There is always a tension between purity and compassion, and proponents of each will often claim that each provides a valuable example. If you want to be a shining example of righteousness, shouldn’t you be set apart and pure? Can you be a shining example of righteousness while toiling amongst the filth of this world, or will it not inevitably contaminate you?
So in a D&D context, I can see this as being a major point of contention even within alignments and sometimes within cults and sects. Should we set ourselves apart in a sacred space, or should we go out and do whatever works are required by our beliefs? And different deities might compel their champions to act differently, and have different requirements for what counted as ‘associated’ with someone who was evil. That probably should be spell out in the code for their champions prior to expecting someone to act the part.