My question (and I think Blackcat's question also) is how do we deal with this? I'm interested in knowing what should I do and say to the school to deal with this situation. Like a script to help us not start ranting.

Because my DS is not happy staying reading the same books at the lower level. Nor am I happy about it. It may not affect other children's learning but it certainly does affect my DS's learning. When he is not permitted to read higher level books his reading level does not move up. He loses out on vocabularly, reading skills, comprehension... not to mention he misses out on challenge (that he loves so much) and growing as a reader. The more he reads and the more he is permitted to move up at his own rate the more he grows as a reader.
So, at present, we are in a situation where he was beyond the end of 2nd grade in the beginning of the year (he's in 2nd). Teacher placed him at that level - the last level for second grade and is leaving him there. If she says in our meeting in 10 days "I can't move him up to where he really is because we cap it. That's where he has to stay," what can I say/do to make this a better situation for DS? Should I just say "look, then I am sending in books whether you like it or not. period." ? To be clear that is what we do now - except now DS puts a red sticker on the book so it appears to others that the book is a book from the "basket" at his designated level so he doesn't get told on or noticed. WE, both DS and I, want to just be able to do this (send in books on his level)legitimately so he doesn't have the constant underlying stress of breaking the rules and basically lying every day.
Also I am concerned about what is he getting instructed on in reading if recognizing his true instructional level is not permitted?