This is a framework issue in Silverlight. The same problem occurs with a normal TextBox and handler to its KeyDown event. The framework doesn't send correct e.Key in the arguments when ctrl+z is pressed. It sends "Control" as key instead of "Z".
The workaround is to create a custom RadWatermarkTextBox:
public class CustomWatermark : RadWatermarkTextBox
{
	protected override void OnKeyDown(KeyEventArgs e)
	{
		if ((ModifierKeys.Control == Keyboard.Modifiers) && e.Key == Key.Z)
		{
			e.Handled = true;

			return;
		}	

		base.OnKeyDown(e);
	}
}