I agree, it's a very curious word.
I just checked http://www.thefreedictionary.com/sanction to see if it offered any clarification, and the answer seems to be "not much".
Note their definition #2 for the verb form, "To encourage or tolerate by indicating approval." Then right below it is definition #3, "To penalize, especially for violating a moral principle or international law."
In practice, to tell which it means you have to read the context. "The government officially sanctions the use of solar power and offers numerous special tax breaks to encourage it." Versus, "The government has officially sanctioned the use of incandescent light bulbs, and they will no longer be permitted to be sold after 2012." [After some research, I do not stand by that last example.]
There are several words in English that are their own antonym. I find them rather amusing, myself.
In reply to FumbleFingers: I'm not sure what you would define as an "authoritative source", but here are a few examples of use of the word "sanctioned" that I've managed to find in a quick search:
A press release from the U.S. State Department: "Seven Companies Sanctioned Under the Amended Iran Sanctions Act". These companies were penalized.
Headline from the UK Guardian (newspaper): "Air pollution in Britain: state-sanctioned mass poisoning". The state approved the "mass poisoning".
Jerusalem Post: "Normal China-Iran business ties shouldn't be sanctioned" Read the article and it's clear that they mean that such business ties shouldn't be penalized.
Daily Gazette (Schenectady, NY): "Union sorority sanctioned over drinking at Oct. 7 party". Meaning they were penalized.
Washington Post: "Secret U.S. memo sanctioned killing of Aulaqi". U.S. approved it.
Catholic Charities web site: "Only approved sanctioned events are posted on our listing." (describing youth athletic activies) The organization approves these events.
Human Rights First web site: "Yemeni Government Contracted With U.N. Sanctioned Arms Dealer". The article indicates that the UN criticized the arms dealer in question.
Huffington Post: "The Pakistani government 'sanctioned' the killing of a journalist last month, the top U.S. military official said Thursday ..." They're saying the government approved the killing.
news.yahoo.com: "How widespread is teacher-sanctioned cheating?" Meaning teachers approving of cheating.
(I don't think that all of the above sources are "authoritative" in the sense that I believe their content to be accurate and unbiased, but they are all people whom one would reasonably expect to be competent writers.)
After going through dozens and dozens of examples, I come down to observing this pattern: If you say that a person or an organization was sanctioned, that means that they were penalized or some disapproval of them was expressed. If you say that an action or event was sanctioned, that means it was approved.
I thought that I had read examples in the past where it said that an action was sanctioned meaning that it was prohibited, but I am not able to find a quote like that from a grammatically-reputable source now, so I withdraw that portion of my answer above.