I mean, if a contractor has already proven he/she does the real, actual, job well, and gets along with the team well, is it fair to make their future career depend on whether or not they can, say, convert a linked list to a balanced binary tree on the spot on a whiteboard? (arbitrary problem for sake of illustration).
As opposed to taking on a fresh FTE who, as you put, only had 1-2 days of interviews to determine any sort of fit - technical or cultural.
That leaves the possibility that the contractor was unlucky, since even the best interview process will generate some false rejects. I believe the extra familiarity that a quasi-internal candidate has with the group's work (and thus the kind of stuff we're likely to ask) should more than offset that, though.
This whole paragraph sounds very weird to me. It runs completely opposite to my experience.
I have never worked at a place which made contractors go through technical interviews. That sounds like a huge waste of time when you already know how they perform. Interviewing is costly.
In the field I used to work for, hiring contractors was seen as a major pain because you had to be careful about not spoiling your relationship with their current company and contracts tend to have clauses about "poaching". It was never done unless you really wanted the guy.
And the agencies are absolutely fine with it. Sometimes there's a buyout fee, but not a big deal. The agencies are pretty interchangeable anyways, so they can't be too picky.
And yes, software developers do go from contract to FTE. The interview process may become somewhat pro forma in that case, since the options are to hire as FTE, fire as everything, or get somewhat awkward. So probably sometimes that lets candidates who couldn't have passed normal interviews slip through. In a certain sense, that's fine, since you've had much more time to assess your contractor, and probably already made a better determination than even the best 1-2 day interview process could. That does feel unfair, though; and since your contractor knows the group's work well and interview questions usually (should, at least) relate to that work, they should be coming in to your usual process with a strong advantage.
So I personally try very hard not to start interviews for a quasi-internal candidate unless I'm confident they'll pass the usual process, and encourage interviewers to evaluate with their usual rigor. I've seen managers deliberately bring in interviewers outside the group too, both to improve objectivity and (hopefully) to make an introduction that the candidate will find valuable in their new FTE job.