Why does sed not replace overlapping patterns

I know you want sed, but sed doesn't like this at all, it seems that it specifically (see here) won't do what you want. However, perl will do it (AFAIK):

perl -pe 'while (s#\t\t#\t\n\t#) {}' <filename>

As a workaround, replace every tab with tab + \N; then remove all occurrences of \N which are not immediately followed by a tab.

sed -e 's/\t/\t\\N/g' -e 's/\\N\([^\t]\)/\1/g'

... provided your sed uses backslash before grouping parentheses (there are sed dialects which don't want the backslashes; try without them if this doesn't work for you.)