I'm not positive about this, but to my knowledge, a knock sensor is actually a microphone that listens to your engine for detonation (also calling pinging). You get detonation when you have air/fuel that explodes when you don't want it to (in your intake manifold or before the piston has reached TDC on the compression stroke). Detonation is very dangerous and will destroy an engine. You get detonation from extra heat caused by either running lean (or higher compression, a turbo, SC or N20 ...) or lower octane gas which is easier to burn and hence easier to detonate.

The computer increases the amount of ignition advance to a set point. If it detects knock, it backs it off. This allows you to put 87 octane in your motor without it blowing up, but it will loose power. If the sensor is disconnected or damaged, most likely the ECM will throw a MIL and cut the power (also known as limp mode) simliar to what it does when the O2 sensor goes. Basically the ECM isn't getting feedback so it plays it safe. Definately replace it. Seeya.