This is due to your copy operation being done completely on the client-side. This operation does not include any merge tracking information and so when you attempt the merge it tries to add file1 on top of itself. This behavior is described in the disclaimer in the help for the...
Though I was not able to identify the main cause of the problem but my Subversive plug-in was 6 years old and that could be a possible reason. The way I created branch was perfectly correct and to verify that I ended up installing Subclipse plug-in instead and using Team...