During the American Civil War, as it was well known that Liverpool supported The South, Lincoln had placed more Union spies in the town than he had operating in the rest of the world. This was due to the fact that not only was the trade between the South and Britain being directed from there, but also because Liverpool was a major ship builder and it was known that ships were being built for the Confederate Navy there.

John Laird's shipyard was secretly building two iron-clads – ships armored with iron and having twin rotary turreted cannons. At the time, they were the most advanced battleships in the world. If theses ships were delivered to the Confederacy, they would have easily decimated the Union's fleet.

The spy network forwarded information about these ships back to Washington and when Abraham Lincoln became aware about them, he was furious. He actually threatened to declare war against Britain if the ships were delivered to the Confederacy. Britain was officially neutral, but once the government had been convinced that the iron-clads were for the Confederate cause, they set out to stop the builds and destroy what had already been completed. After finding out how advanced these ships were they actually allowed them to be finished and launched - after, of course, they had been claimed by the Royal Navy.

The Union had to provide extensive and decisive evidence before the British government would act in regarding seizures of ships, but even then, it would be difficult to stop the ship from making its way into the Confederate Navy. An example being the CSS Alexandra. She was seized whilst being fitted out in Liverpool but was then sold on to a Liverpool merchant who, it turned out, was sympathetic to the Confederates.

Liverpool's involvement in the North/South conflict was so deep that after the war, the United States demanded extensive compensation for the damage caused by the mainly Liverpool-based confederate ships, especially Laird's built CSS Alabama.

Known as Alabama Claims, an arbitration panel in Geneva awarded the US $15.5m. To put this in perspective, the reparations awarded were more than it would have cost to build more than 150 fully armoured ships - a greater number that that of a whole fleet. This award seems rather harsh considering that the British government did act up on any validated information and did seize any ships that they knew were destined to join the Confederate fleet.

That is just a snippet of what was going on at the time, but gives a pretty good overview of the complex relations between the Union and Britain. Britain was officially neutral, but had its major port dealing illegally with the Confederacy. If the British government were to wade heavy handedly into Liverpool and shut down everything that may have had Confederate connections, trade to the Empire and colonies would be massively affected, so what illegal affairs did go on were allowed to pretty much unchecked - unless it got out of hand or the Union forced the British government’s hand on the matter.

Lincoln knew how little was being done to stop what he considered a great infringement on the Union’s cause, but he had no concrete evidence that this was the case. He also knew that if he over-played his hand with the British government about not doing enough, there would be a great chance that the political relations between Britain and the fledgling US would be irreparably damaged before they had even got off the ground.

Lincoln was politically stuck between a rock and a hard place, but managed to keep things relatively friendly, diplomatically speaking, between the Union and Britain. An absurd situation when you think about it, as most of the funds, armaments and ships being used against him were flowing directly from the country he was trying to be friendly with. But as Napoleon Bonaparte once said "In politics, an absurdity is not a handicap."

EDIT: I just realised that I didn't really answer your question!

Trading in cotton between the South and Europe wasn't illegal, but it was actually embargoed by the Confederacy itself! The idea being that starving Europe of cotton would bring them around to the Confederate cause and force them to assist in the war against the Union. The cotton famine hit Liverpool trade hard, so motivated by the need to make money, the Liverpool merchants worked with the South against the Union by taking their money in return for ships, and the transport of guns, cannon, ammunition and other supplies, hence the reasoning for what I described before the edit.

Some cotton did manage to come through from the South, but it was very little and by this time trade with Egypt and the East Indies for cotton was starting to pick-up, so reliance on American cotton was starting to dwindle. Even so, there was a great bonhemie between the Liverpool Merchants and the cotton producing states and it was this, along with the opportunities in delivering war supplies that kept the relations between the town and Confederacy so high.