Did Death know Blair was a cat and not a witch? At the start of Soul Eater, Maka and Soul are tasked with hunting the soul of a Witch to turn Soul into a Death Scythe. The target is normally assigned by Lord Death as to avoid the Meister/Weapon group from getting killed.

During Maka's/Soul's fight with Blair, Death comments that there's "something odd" about her (right before he Reaper Chop's Spirit for Spirit's comment on Blair's body), then we learn she is actually a cat with a lot of magic. As a consequence, because Maka and Soul messed up the final soul, their previously collected 99 souls were confiscated.

From what Death said during the fight, it didn't seem as if it was a test to see if Maka and Soul could correctly identify a Witch. So I am wondering, did Death know Blair was a cat? If not, why did Maka/Soul get punished when he himself thought that she was?
From what I remember, the 99 souls were not actually confiscated. Because the 100th soul he ate was a cat's, he had to repeat the whole process of hunting 99 red souls again.

Think of this as a "soul-meter", the goal is to fill it up to 100 (99 being red souls and a soul of a witch). Initially, he had 99 souls already eaten, and he had one more soul to go.
He then mistakenly ate a cat soul, thinking it was a witch. This caused the gauge to drop back to zero.