I assume you meant Twilight Knife? Or is there a Twilight Dagger spell I can't find in the SRD?
Reading Twilight Knife, the knife automatically moves to flank any creature you attack. That's handy. It's also probably small enough to enter an enemy's space, much like a tiny creature must do, which might be useful at times.
Can it flank from inside an enemy's square?
No. Here's why:
When in doubt about whether two characters flank an opponent in the middle, trace an imaginary line between the two attackers' centers. If the line passes through opposite borders of the opponent's space (including corners of those borders), then the opponent is flanked.
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If the knife is in the enemy's square, and then you draw that imaginary line from the center of the knife/enemy to your center, that line will only pass through one side of the enemy's square. There is no way for it to possibly pass through two opposite sides if it originates from within the enemy's space.
So while the knife can probably enter an enemy's space because of its tiny size, it certainly cannot flank from inside the enemy's space.
Tiny creatures normally cannot flank, as they must enter the same square as their opponent to threaten them. You can't draw a line from the center of a square to that same square that passes through opposite borders of that square.
Since twilight knife overrules this by saying it always maneuvers to flank, that could be taken one of at least two ways:
1. The knife is not Tiny (perhaps there's a bodiless rogue holding it). The knife has its own square and cannot enter another creature's square unless the size difference is sufficient.
2. The knife is Tiny but automatically flanks regardless of the usual flanking rules. It enters the opponent's square and is automatically considered flanking at all times.
I would rule 2, but since the fact that it flanks goes against the normal rules for Tiny creatures, I have no idea. An argument could be made that it isn't a creature and thus the size rule doesn't apply, thus 1.
I would rule as it is tiny creature with reach of 5ft, because dagger itself is tiny but it uses his whole body to attack as weapon of medium creature.