successive British governments demonstrated no understanding whatsoever of the situation in Northern Ireland and extraordinary arrogance, particularly Margaret Thatcher.
The big mistake (if you concede that the UK had to create Northern Ireland for political reasons) was in not drawing the borders in a more sensible way. They left areas with strong nationalist tendencies in the UK, and it was a terribly stupid mistake. I understand that the idea was that they wanted Northern Ireland to be economically viable, but what they came up with was just a stupid and unworkable arrangement. If the borders reflected the will of locals, then Northern Ireland should have been quite a bit smaller. It would only have left West Belfast as an issue, and that could be easily managed by giving them their own elected administration with the same powers of the Northern Ireland parliament.
Had they left South Armagh in the Free State, it would have become a problem for them and not the UK government. People think that South Armagh is a modern problem, but it seems that they've had problems with outsiders for centuries, not just 50 years.
Once the damage was done, it was impossible to change things. You're absolutely right that British governments had no real grasp of the issue, especially when you realise just how much money and effort was being spent on securing the province. I'd even argue that the current government is clueless, because they're turning a blind eye to the punishment beatings going on now, and they don't seem to have any creative ideas at all for how to restore the NI Assembly.