arusaku: I will add my two cents in terms of weapons and leveling, since I used to power-game RTK quite often in my youth. Keep in mind this is all from memory, since I am at work.
The best weapon for James can be found in Chapter 0 or any of the chapters that allows you to explore the city of Krondor.
If you really want to get the best weapons, simply keep going around the city, find a door, go into it, fight random encounter, heal up, sell any unneeded loot and identify any items you happen across. Rinse, lather and repeat. I have ended up with James being level 16 at the end of the game on multiple playthroughs by powergaming this way. It isn't necessary, but you get the best equipment and cash this way.
Here are the best weapons for James:
Wrath of the Prophet: Looks like a golden scimitar. While it does a penalty to your Attack rating of -15 to -25 (I can't remember, someday I will post a guide on the net to all the weapons and everything in this game), it does the most damage in the game by far. In the end game you end up doing 80 damage per hit and with the right rings (i.e. Ring of the Winds is probably one of the best) and items you can end up doing 400 damage in a round (5 attacks).
Bow of Kahooli: This is honestly a ridiculous bow and is useful on the areas where you could use a ranged weapon (you won't encounter any until you travel outside of Krondor). It does insane amounts of damage. It looks like a bow that has a silver string and silver covered limbs.
I will add more weapons at a later date, but I know that the Wrath of the Prophet always ends up being my favorite weapon for James with its damage potential.
Best Armor For James (From best to Worst with respect to body part covered):
Dragonskin Jerkin (Torso): This armor not only allows you to be bulletproof to many attacks but allows you to be immune to all fire damage. This is awesome, since many enemies use fire oil, fire magic and other fire based attacks due to special magic weapons. Dark leather jerkin that is huge.
Komodoskin (or something like that) Jerkin: It is strong armor and does have resistance against some attacks. Dark leather jerkin that is huge.
Enchanted Leather Jerkin: This is the bare minimum torso armor you should have with James before you leave Krondor. It and the Komodoskin are equal in many ways in terms of protection, so they can be swapped. Personally I like the way this piece of armor looks. It is a shiny red leather jerkin.
Enchanted Leather Vambraces and the Leggings (I forget what they are called): Again, don't settle for any vambraces and leggings that are just studded leather. You need this enchanted armor to be able to have James as your tank for most of the game.
I won't post anything for the other characters, since I don't want to spoil the experience for you. But those are some items that are the best in the game.
Oh I remember now. There are some great magical rapiers for James as well. But, the trade-off for those weapons is they allow you to have slightly better chances to hit, but much less damage then the wrath of the prophet.
The main thing to remember in this game is that James need to have maxed out attack and defense, with the rest of his skill points placed into thieving skills and initiative (determines if your character gets to move/attack first during a round of combat).
Again, I might need to put together an in-depth guide to this game.
But, I am here for other questions.
Much thanks, arusaku, for your very informative post. It would be great to have a list of magical items found in the game, and also how they work magically. I picked up quite a few and it was very frustrating not knowing what exactly a magical piece of equipment does or how it works. After accessing it provides no further clues as all the info given is some rather vague description of the the weapon / armor.
By the way, anyone knows what the Ironskin Jerkin does? It says "magical quality" but I'm not sure how. Is that a better armor than the regular Keshian leather jerkin?