This is basically we can't country restrict O365 storage/processing isn't it.

We can spin up a custom instance for a huge amount of money effort (e.g govcloud) but off the shelf it goes wherever there's free space or similar?

Good? Law enforcement shouldn't be relying on pinky-promises of foreign corporations that they'll keep information confidential anyway, so if this keeps them from using MS SaaS, all the better. That this will force Scotland to develop enough native IT expertise to replace these services (which may one day grow into a viable business) is just an added bonus.

What world are we living in where companies get to tell governments to piss off?

Is it just me or this a non-story? Police Scotland (rightly, and apparently thoroughly) did due diligence on whether O365 is suitable for their use case, and Microsoft (rightly) told them no it’s not. And yet somehow there’s a Lib Dem peer saying we need “UK Cloud capability” as if it’s some sort of nuclear arsenal rather than software running in data centres.

Well, it’s weird to say this, but good for Microsoft. The UK is turning into an Orwellian state.