The problem is that the signal emulation won't interrupt a blocking read. That's because the read runs in the kernel space, but the emulation runs in user space. It's a bug in the emulation, but not one that is easily corrected.

The following small mod makes it work well enough for most purposes:

#! /usr/bin/perl -w

use strict;

# Starting a co-process to read from.
my $procid = open(READ, '-|',
    'perl -e "$|=1; for ($i=0;$i<10;$i++) {print \"Line $i\n\"; sleep 
+1;}"'
);

my $timeout = 0;
$SIG{ALRM} = sub { $timeout = 1; };
alarm(3);

# Reading from co-process.
while (!$timeout) {
    my $line = <READ>;
    last unless defined $line;
    print $line;
    sleep 1;
}

kill('INT', $procid) if $timeout;
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