Your school is obviously teaching the children well if your year two children are already making such excellent progress.
If your children are already a level 3 then the particular 'sub division' of level 3 would make no difference to value added results so this would not make a case of 'holding back' results.
As to the example you provided regarding reading levels, it is entirely likely that both children are level three despite one child having a higher reading age. Without knowing which 'reading age asst.' was used it is hard to comment but most tend to put the weighting on decoding/fluencly and word per minute type exercises.
To be teacher assessesd as a level three reader, decoding is an expected skill and greater weighting is placed on areas such as:
deduction and inference
ability to comment on structure and organisation of text including grammatical features at text level
ability to comment on writer's use of llanguage, including grammatical features at word and sentence level
ability to comment on writers'purposes and viewpoints and effect on the reader
relate texts to their historical, cultural aand social traditions.
As a teacher I would be happy to provide evidence of how I calculated a level for any of the children in my class. You say you are surprised by a couple of the teacher assessed levels on your child's report. Have you gone in to the school to discuss this with the school or just asked for test results (a very crude marker of individual ability).
I am not sure why your school won't release their test results to year two parents (we do) but to be honest if the parents of thirteen year two children all complained about not getting them then he perhaps feels that too much emphais is being placed on them (by parents) and would prefer to give the much more realistic and informative teacher assessed levels.
All the best