Someone who takes political correctness to the extreme; reads way too much into perfectly innocent statemens. The rainbow sheep will find something racist/sexist/generally non-PC in almost anything, and causes annoyance by constantly telling people off and trying to censor things when it's not necessary.
This includes wanting all Christmas cards to say "Season's Greetings", not "Merry Christmas" and berating people for using the word "black" even in the context of describing the colour of a dinner suit.
The rainbow sheep might claim to be a human rights activist, but usually they are just seen as a party-pooper.
Rainbow sheep are usually white and middle or upper-class, but are often unable to admit this.
According to Freudian psychology, the Rainbow Sheep is using a defence mechanism called Reaction Formation. This means that they actually have unconscious racist/sexist/non-PC views which they fear, so they make sure that their outward behaviour is the exact opposite to what they really think.
This term was coined upon hearing that schoolchildren were being taught to sing "baa baa, rainbow sheep" instead of the traditional nursery rhyme, "baa baa, black sheep".
"we won't be putting Christmas lights up this year because we don't want to offend people of other faiths"
"oh, don't be such a rainbow sheep".
"He accused me of being sexist when I asked if the milkman had been round. He told me I should say 'milkperson' instead. What a rainbow sheep".