What exactly is the reference to of the word “thereof”? To me it looks like it refers to “an establishment”. So read literally, Congress is prohibited from prohibiting an establishment.
It doesn’t seem right to say that that thereof refers to “religion”.
Is that right?
It refers to religion. Congress can’t establish a national religion (for examples, we are not like countries that have established Islam as their national religion) and they can’t surpress the expression of any religion. Linguistics has changed over the years. After all, how many times a day do you use “thereof” in conversation? 
I know that is how it has been interpretted. I am asking what it literally says. But the point about different usage is well taken, it may have used differently in the past.
It has to refer to religion. Take your alternative. You can’t prohibit a free exercise of establishment. Grammatically, the sentence allows only the one interpretation. It literally means exactly what everybody takes it to mean.
Suppose this were stated in modern (and slightly simpler) language. It would say something like this:
> Congress may not pass any laws related to the establishment of religion, nor
> may it prohibit people from freely practicing it.
Now it’s true that, just purely by looking at the grammar of this sentence, one could understand the second clause to say that “freely practicing it” means “freely practicing the establishment of religion” rather than “freely practicing religion.” That doesn’t make much sense though. Only a government can establish a religion, not an average person. It makes much more sense (from the meaning of the words in this sentence) that it says that they can’t prohibit people from practicing religion.
Interpreting a sentence is not just about grammar. You have to know what the words in the sentence mean and about how the world works. The best interpretation of a sentence is one that makes both grammatical and logical (or perhaps I should say “semantic”) sense. The worst that I can say about this sentence in the Constitution is that perhaps the drafters of the Constitution should have been a little clearer in their grammar.
But since at the time the Bill of Rights only applied to the feds maybe what it is saying that the feds won’t pass any legislation to establish a religion and the feds won’t pass any legislation to prohibit the states from establishing a religion.
Does that make any sense?
You make an interesting case, however your interpretation is more narrow and doesn’t add anything new.
Current interpretation: Congress can’t make laws establishing a national religion and congress can’t make laws preventing one from practicing a religion.
Your interpretation: Congress can’t make laws establishing a national religion and congress can’t make laws preventing a state from establishing a religion.
However, under the current interpretation congress already cannot pass a law preventing a state from establishing a religion because that would violate the free exercise clause. In fact, I don’t think anything will stop a state from adopting a constitution that starts with “We, the People of the State of California, grateful to Almighty God for our freedom, in order to secure and perpetuate its blessings, do establish this Constitution of this Christian state.”
Now, in practice the free exercise clause is very limited. Take for example the Civil Rights Act of 1964. It clearly controls discrimination on the basis of religion. Discrimination on the basis of religion is inherent in the practice of many religions. If I want to start a national fast food chain that does not allow Christians on the premises, I’m out of luck, even if I go to my hell for not doing so.
IANAL, YMMV.
Even just in terms of grammer, the thereof refers to 'Religion." It’s parallel to the ‘of’ referring to religion before the comma.