Has your daughter been evaluated for sensory integration issues?
I would NOT allow the school to hold her back for her handwriting alone. Yikes! Talk about the perfect formula for making a bored kid who hates school!
Can your daughter type? My oldest son tested as being fine on fine motor skills, but had horrible issues with writing (he is also fine/advanced in other areas). We homeschool now, but before that, we insisted the school have tolerance for his handwriting--and we let him type up many, many of his assignments. It was more important to me that he get the practice at getting his thoughts out of his head onto paper than he have legible handwriting.
He is in 6th grade now and is able to handwrite a 99% legible 5-page report in almost no time. It just took a while for those skills to develop. I was very careful to encourage, but not force the issue.
Especially in today's day and age--outside of school, so much of our written communication can occur through a word processor....
I guess if the school were pushing things, I would ask for them to provide *written* justification of holding her back and then I would address each item in their list--why you don't think it is an issue or how your daughter can work around it to continue to succeed in 3rd grade.