The Bloody Papersheets on the Gnolls quest state that this quest within a quest is levels 2-7, however, when we attempted to start it, it said the maxe level was 4.

Fairly certain that Gnolls is 3 - 7. Has that been changed?

The "Bloody Papersheets quest" said it was 2-7, if I'm not mistaken.

Confirmed.

Double confirmed, I was there with Halfbrood when the bloody parchments were bugged.