What he means by "don't knock yourself out" (which, by the way, IS sarcastic)... in other words "don't compliment me *too* much". Although, he's teasing her because he knows that ISN'T what she means. He just wants her to realize that she's not picking her words carefully and it sounds as if she's insulting him.
Game, set, match.
Thank you both for taking the time to answer! Now it's clearer. Although I realize it was more a matter of reading between the lines... Gosh, these two are pretty complicated! :P
