Being told a conflict of interest is acceptable for paper review I was recently asked to review a paper. I feel like there is a conflict of interest as (i) I frequently collaborate with one of the authors, (ii) I discussed the paper with the authors while they were working on it, and (iii) I am currently doing follow-up work (i.e. extending the work of the paper in question).

I told the program committee member who asked me to review the paper all of this. I was surprised when she responded saying that this is not an issue. Specifically, she responded that this is unavoidable as there is a small community of experts who all work together and that this just means I'm the most qualified expert to review the paper.

What should I do? Should I accept the PC member's assertion that this is OK? (I have been honest with her.) Or should I insist that I am not able to give a fair review?
From an outsider's perspective, both choices are now ethically just. You've declared the potential conflict of interest and been assured that the authority in question doesn't see one ( hopefully you did this through a means which let you keep a record).

So now it pretty much comes down to whether giving the paper a fair review makes you feel uncomfortable. If it does, then get back to the committee as soon as possible, and tell them as clearly as possible that you can't do the review. Otherwise, review the paper, making full use of your deep understanding of the context of the work.

If you're wondering whether the committee member's statement is ethical, then consider whether you, as an obviously knowledgeable person in the field, could think of three other possible reviewers. Of course, if you can, then maybe one answer is to say no, but pass on those names instead.