It's difficult. I know exactly how you feel and it's very frustrating. Here we are, busting our butts, being honest, and giving great customer service. Then here's your competitor paying for 5 star reviews and he/she has more than you.
Here's one thing to keep in mind: Dishonest people are often bad people. Even though they pay for reviews, it's in their nature to treat customers like a number. It's been my experience that crappy business owners pay for it in bad reviews. They may have hundreds of fake 5 star reviews like a few of my competitors, but the bad ones are really bad.
Here's another tip: How you respond to bad reviews is very important. In fact, I'd say it's the most important thing. From time to time a bad review is justified. My advice: Own up to it. You're not perfect. Be honest and fair with people. Apologize for your mistake and find a way to correct it with the customer.
Another tip: Don't do automated responses to your reviews. Your customer took the time to review your company, take the time to respond. Yes it takes a lot of time. I spend 6 hours a week personally emailing each of my customers asking how they liked my service and responding to reviews left for my company. I appreciate my customers. You should too.
Back to the question at hand: How do you deal with a competitor paying for 5 star reviews? The answer; It depends how how they're obtaining those reviews. Here are a few ways they do it:
They pay a service (outside the U.S.) to give them 5 star reviews.
They pay their customers to give them 5 star reviews.
They create fake google accounts and give themselves 5 star reviews. This is a dangerous one because sometimes they'll use fake google accounts to give you (their competitor) 1 star reviews. I've had this happen to me quite a bit.
Google has ways to determine fake reviews that come from shady companies outside the U.S. However, some of these companies are getting really good at what they do. All you can do is hope Google picks up on it. From my understanding, the consequences are stiff.
If your competitor is creating fake Google accounts, all you have on your side is time. After a long period of inactivity, eventually the account will be closed. Once it's closed, the review drops off. One of my competitors did this, giving himself 5 star reviews and me 1 star reviews. They screwed up and gave 1 star reviews to other companies like mine as well. Together we contacted Google and they got the reviews removed and their accounts were closed. The business got to keep all the rest of their reviews though. I would have hoped that the penalty would have been much stiffer.
Paying customers to give you 5 star reviews is really shady in my opinion. Again, I have yet to see any consequences from Google to my competitors who are doing this. I've seen them pay money right out of their pocket. I've also seen them offer a percentage refund (10%) if the customer gives them a 5 star review and includes pictures. Again though, they pay for this shady crap one way or the other. It's pretty entertaining to read the 5 star reviews some of my competitors get. The best 5 star review I saw was simple: "Worst company I've ever had to deal with. They SUCK!"
Here's the thing though about reviews. People generally only read the bad reviews. I think people are looking at two things:
What are the problems with this company
How do they handle the problems
This is where you should own up to your mistakes, and NOT in an automated response.
As for the legal aspect of paying for fake reviews: Yes, it's illegal, but good luck trying to get the Federal Trade Commission to do anything about it. It got really bad for me at one time. One of my competitors (a really shady person) was hammering me with 1 star reviews and loading up his account with 5 star reviews. It was more than obvious. Evan with proof, I couldn't get them to do anything about it.
Bottom line: Shady people do shady things. The only justice is that they'll do shady things to their own customers and pay for it in 1 star reviews. Most likely, the owner will lie, claim this isn't their customer, and act a fool in his/her response to the review. All we can do as consumers is pay attention and not do business with folks who are obviously paying for reviews and / or not handling their problems properly.
Another tip: Do what you do. Don't worry about your competitor doing shady things. They'll pay for it one way or the other eventually. It's just like you tell your employees: "Don't worry about what a co-worker does or doesn't do. Focus on your job".