Curunauth: You may have run afoul of the Chapter 2 trigger that is supposed to make this happen if you put him in jail in Chapter 1 (he gets out and causes this trouble). That or you spoke to Pablo and admitted that the poster is of you, which made him talk to Andre, which would (were Canthar in jail) have gotten him released and allowed him to exact this revenge. Either trigger might fail to check for you complying with his blackmail.

There are 2 ways to more effectively deal with him, avoiding the 500 gold penalty AND the moral unpleasantness of doing his dirty work.

First: if you avoid talking to him initially until you get farmer's clothes (it'll cost 10 gold more, since you can't complete the frying pan quest first if you do this), you can convince him you're a farmer, and the quest string never comes up; he won't bother you again.

Second (and more fun!): take his quest, but turn the jerk in to Andre. You get the same bounty, he'll go to jail, and if you chat with Sarah, she'll reward you with a comparable weapon and more XP. Then, visit him in jail and silence him - permanently!

The second can be a bit tough, as he's a good fighter (+300XP) and carries a longsword to jail (wtf). If you provoke him and run out, the guards will attack him, but you can't murder him in front of them, and if you pick up the sword, they'll consider it stealing. Still, you can let them do that, then once he's back up and returns to his cell (at 1hp and no sword), provoke him again, draw him to an out-of-sight corner, and kill him. (Warning: the jail guard can see you through the wall in some places, so you'll have to experiment. I found it worked well to get behind the little bookcase, so the corpse and I were both along the side wall.)

Another, somewhat dirty way of killing him (but then, he's a right bas*%$#) is to climb up the high post of the bookshelf - it's too small to move around on at all, just out of melee reach, and he can't climb up when you're on it - then fire arrows at him. Be careful that he's out of sight of the jail guard when the killing shot lands though - and even if he is, his sword might land somewhere the guard can see it, in which case taking it will be theft. Also, you'll need to hold the walk key the whole time - drawing a weapon, switching weapons, aiming, or firing ALL involve shuffling your feet and you will fall off if you're not holding the walk key.

Final note: he does not retain his store inventory, so you can't exploit this to double your money. Furthermore, he has a small random inventory if KO'd (a bit of food and ~17 gold), but nothing if killed. To get the absolute most out of him, you have to KO him first, which means something other than arrows for the final blow.