As far as the mortgage situation, you need a H.O. insurance binder to close on a mortgage.
However, I think that you CAN get a HO policy- you will have to shop around a bit with different companies and you will end up paying more for this policy. All of that is on your lap and the seller really wouldn't care about it.
Best bet is my note on the inspection clause in the P&S.
Hope the seller is willing to talk about it further... Thanks and good luck,
Check back and let us know how it works out,
Not likely that you can renegotiate anything on your P&S regarding this issue but your insurance agent may be able to work something out with the insurance company, if you are going to get rid of the knob and tube as soon as you close. Another option may be to look into getting this removed prior to obtaining an insurance policy and closing.
You'll be happier without the knob and tube.