If you use localbitcoins to buy and sell a small amount of bitcoin, that is not a business.
Since my case was dismissed before it went to trial this was not decided. Whether this it is a business or not currently can only be decided by a jury.
It is not a money transmitter.
Also not true. You would have to argue this point with motions before a judge and then possibly a jury. This would have been an argument in my case but again the motions were never filed and the case did not go to a jury.
But you have declare that you do not deal with drug dealers.
And this would help you how? Sure, if someone says "I am a drug dealer" or "I am an undercover cop pretending to be a drug dealer" or "I am an undercover Homeland Security agent" then you should not trade with them. But all of these guys will lie to your face. Then what?
The bitcoin you sell should not be used illegally.
In my case the only legal issue was whether it was a business or not. If you use your Bitcoins to do something illegal, for example to buy a controlled substance with them, that would be a whole different case. Anyway, how would you go about enforcing how the Bitcoins bought from you on localbitcoins eventually get used?