You might want to read Google's Blog post about the introduction of google.cn: http://googleblog.blogspot.com/2006/02/testimony-internet-in-china.html
The short of it is that since google.com wasn't self-filtering, the government was filtering at the border, which led to slow and unreliable service, in addition to the filtering. Google decided that on the whole, it was better to provide an additional filtered local (and thus reliable) service than to leave the chineese with only a service that didn't work well (from the user's standpoint). And since it was additional, they didn't take away anything.
That, and it was good for business.
From the 2006 post, edited for length:
[In the fall of 2002, Google suddenly became completely unreachable from within China. Google did nothing, and about two weeks later, it could be reached again.]
However, we soon discovered new problems. Many queries, especially politically sensitive queries, were not making it through to Google’s servers. And access became often slow and unreliable, meaning that our service in China was not something we felt proud of. Even though we weren’t doing any self-censorship, our results were being filtered anyway, and our service was being actively degraded on top of that. Indeed, at some times users were even being redirected to local Chinese search engines Nevertheless, we continued to offer our service from outside China while other Internet companies were entering China and building operations there.
[much later in the testimony]
Since 2000, Google has been offering a Chinese-language version of Google.com, designed to make Google just as easy, intuitive, and useful to Chinese-speaking users worldwide as it is for speakers of English. Within China, however, Google.com has proven to be both slow and unreliable. Indeed, Google’s users in China struggle with a service that is often unavailable. According to our measurements, Google.com appears to be unreachable around 10% of the time. Even when Chinese users can get to Google.com, the website is slow (sometimes painfully so, and nearly always slower than our local competitors), and sometimes produces results that, when clicked on, stall out the user’s browser. The net result is a bad user experience for those in China.
The cause of the slowness and unreliability appears to be, in large measure, the extensive filtering performed by China’s licensed Internet Service Providers (ISPs).
Even when Google is reachable, the data indicates that we are almost always slower than our local competitors. Third-party measurements of latency
Based on our analysis of the available data, we believe that the filtering performed by the international gateway ISPs is far more disruptive to our services than that performed by smaller local ISPs. Because Google’s servers have, to date, been located exclusively outside China, all traffic to and from Google must traverse at least one of China’s international gateway ISPs. Accordingly, Google’s access problems can only be solved by creating a local presence inside China.
Operating without a local presence, Google’s slowness and unreliability appears to have been a major – perhaps the major – factor behind our steadily declining market share. According to third-party estimates, Baidu has gone from 2.5% of the search market in 2003 to 46% in 2005, while Google has dropped to below 30% (and falling).