Hey so I just finished this quest a while back and saved the dwarf.
I remember getting a clue somewhere about how the dwarf needs to be "tortured" first before you can save him.
Basically you have to hurt him while he's chained up until he gets knocked down and a different dialogue will pop up.
Then heal him up and do it again and eventually when you talk to him the spirit will sound super aggressive.
From that point you can heal him all the way up because after you break the chains the spirit will come out of the dwarf straight away and the battle will start immediately so you want to make sure the dwarf has health so you don't accidentally kill him.
It's a tough battle because as soon as you damage the spirit enough, he just possesses one of your companions and it does it like 3 times.
My suggestion is to maybe give your party crap gear when doing this quest because when it possessed my Red Prince melee tanker, omg he was soooooo hard to kill just to get the spirit out and then spend a res scroll getting him back to life.
Hope this helps
