The attack scenario you came up with it incredibly expensive, and then uses that expensive hardware in the most ineffectual way possible.
Well, yes but you don't care about the expenses when you don't have to pay it out of your pocket (remember, it is the *government*. All they have to do is to yell loudly enough into the crowd that cryptocurrencies are only used by cyber criminals to evade punishment for their drug trafficking and child pornography and the crowd won't mind allowing them to use their taxes for taking it down).
With all the time, cost and complexity, if the hashrate fell 99% tomorrow, there would be a consensus of support to hard fork the network and adjust the difficulty. It would take a couple lines of code.
Just today I was thinking about it (actually before reading your post) and I realized that it would be pretty stupid government to attempt to do it. Yes, they might kill Bitcoin as it is but the Bitcoin developers would simply sit down, figure out why it happened, designed a fix and deploy an emergency update that would change the protocol starting from block X (exactly as you say here). What an intelligent government would more likely to do would be to establish some service where people could register their Bitcoin addresses/wallets. The government does not need the private keys, it would just need to know "person with this ID owns this(ese) address(es)". Then those who are not interested in shady business practices would simply comply and continue as usual. This would allow them to focus investigation to those who don't want their ownership of an address becoming public.
If an attacker has 99% of the critical resource, there are far more serious attacks possible. For starters the attacker could mine a never ending chain of empty blocks and prevent any transactions from ever being confirmed again (or at least as long as the attacker is willing to continue). The reality is that a nation state could kill Bitcoin and probably will be able to for the conceivable future. Of course we all know the fact that napster was taken down resulted in the world wide abolishment of p2p file sharing as well. If the US government spent billions to take down Bitcoin, well I can't imagine a more bullish scenario for crypto currency.
This type of attack would most likely not work (modify the client to reject empty blocks when there are transactions to be commited), however a workable alternative would be spamming the network with bitdust, including this bitdust into their blocks. They could also include extraorbitant fees in those transactions to keep people from moving bitcoin with fees lower than this. However even this would most likely not work well.
The strategy I presented allows the attacker to keep himself hidden all the time until he decides to pull the plug. That would cause much more disruption of the network than acting "strange" from the very start of the attack.
They could also try to mine the coins and dump them to an unspendable address to reduce the money supply. However I believe now that it is pretty late for this kind of attack. They could only hope that the resulting reduction of the money supply would cause the money to be awkward to use (imagine how you are going to work with currency with its smallest unit valued at $1000 ... But that problem still can be fixed by starting to penalize coin hoarding by draining the coins out of addresses which show inbound but no outbound activity for too long (I saw some discussion on a more advanced version of cryptocurrency where there were proposals to reward maintenance of full nodes. The resulting cryptocurrency is more robust against malicious proofs of work. See proof of stake for more info.
So right now I can conclude that the scenario I proposed would work ... for a few hours or maybe days in the worst case. Then a patch would be issued, everything would return back to normal and the attacker would find itself wasting a lot of effort in vain. Sure, he would have pretty nice income stream now but that was not what he wanted
.