Since, per MacMillan, the word folks refers to people in general, it would be natural to qualify folks with local, because the question is asking about folks/people who are local.
Inhabitants might work better if the sentence did not contain local, because inhabitants are local by definition. They are not people in general but people who live here, so you are saying local people who live here, which is redundant and probably not as good as saying local folks. And oftentimes tests are looking for the best answer not the only answer.
Also folk is a genuine Old English word, while inhabitant entered English centuries later and is ultimately Latin. So it is conceived of as being more formal and used in more formal or even scientific contexts, while folks is for us common folk(s) speaking everyday non-formal English.
A better choice than inhabitants would have been residents.
You are right to say civil and civilian sound weird and they probably do because they are an adjective and a singular noun, while the sentence requires a plural noun.
Finally, many multiple choice questions are poorly written and actually do give more than one answer that is correct. Sometimes all of the choices are correct. Inhabitants is not flat out wrong here. I'm just trying to think of reasons I would use folks instead.