They do more with it than place ads. In a decade or two, Google will have amassed the worlds largest and most detailed marketing and demographics database in history. And you don't have to have an account to be indexed, AMOF you have just been indexed by sending email indirectly to my address(
jjzeidner@gmail.com ). Isn't being indexed by Google fun!? But things move very fast and I am sure competition will arise, Yahoo has been doing some very interesting things lately. Also there is a healthy market of 3rd party services propping up.
As for Gmail + encryption, there are, to my knowledge, no explicit terms in their agreement that deal with cryptography. If there were, they are asking for trouble, because it is not difficult to employ encryption techniques that are close to impossible to detect( it is possible to generate an encrypted data block that looks like natural language ). Cryptography in general is an edgy area of law, and much of the precedence that has been set was the result of 'national security' fiat. In some cases Cryptography is viewed as a 'weapon' in a
U.S. court of law. The lines become blurred when dealing with commercial entities.