Jordan Fish from Google Cloud Platform Support helped me solve this problem. He said:
As far as the error message when you try to start the dev_appserver, I believe this is probably due to a vm argument in the run configuration for your project. Can you please go to the run configuration (with the project selected, go to the Run menu and select Run Configurations), click on the Arguments tab, and see what is listed in the VM arguments text box?
Here was my original VM arguments:
-javaagent:C:\Program Files\eclipse\plugins\com.google.appengine.eclipse.sdkbundle_1.9.4\appengine-java-sdk-1.9.4\lib\agent\appengine-agent.jar -Xmx512m -Dappengine.fullscan.seconds=5 -Ddatastore.default_high_rep_job_policy_unapplied_job_pct=50
Here is what I changed it to (added double quotes around the directory that's passed as the -javaagent: param):
-javaagent:"C:\Program Files\eclipse\plugins\com.google.appengine.eclipse.sdkbundle_1.9.4\appengine-java-sdk-1.9.4\lib\agent\appengine-agent.jar" -Xmx512m -Dappengine.fullscan.seconds=5 -Ddatastore.default_high_rep_job_policy_unapplied_job_pct=50
This fixed my problem, I was able to complete step "Running project on the Server" from https://developers.google.com/appengine/docs/java/webtoolsplatform#dynamic_web_project