The terms are not "open for interpretation"; to me they are very clear.
What could be open for interpretation is if a particular phone is damaged or not. In case of a disagreement, the buyer could try to use legal means (consumer protection buraue, mediation, lawsuit, etc., whatever that applies) to press forward his allegation that the phone is not damaged and see if the end result satisfies him.
And they reject the old phones even for minor dents.
Those minor dents affect the likelihood of FlipKart selling the phone again, unless they offer a discount. Or would you accept a brand new phone at the usual price that has minor dents? Most people that I know wouldn't.
Are they allowed to put up such a policy where they can call anything as "damage" and not accept the old phone?
If the law does not forbid them (i.e. they are not infringing on consumer rights) they are allowed to put the policy.
As nowhere in the world(*) the local laws force the seller to buy back goods that were damaged by the purcharser, that policy at worst is in line with the local laws, and at best improves customer protection. So probably they are allowed to set it.
Again, if they were abusing the policy by rejecting undamaged phones (let's say they claim that if you remove the plastic lid that comes in front of the screen, or even if they see that the phone has a fingerprint on it), then you could sue because of missleading advertising (in case they had no legal obligation of buying back the phone but they offered the policy) or due to breach of consumer laws (in case the laws forced them to buy back undamaged phones).
But it will be left to the relevant authority to determine if a phone is "damaged" or not (and again, the fact that minor dents will probably lower the reselling value of the phone means that they have at least some point to claim that it is damaged).
* That I know of.