Your right,i found him there as well(after a long time),i searched the whole place except that particular house(for some strange reason)
I think the correct way to do the quest is:
1.Scry for the member
2. Talk to him
3. Talk to the mayor
4. Talk to the elf.
5. Talk back again to the mayor
6. Try and find the beer(optional) which the mayor requests.
7. Talk to other dwarves( esp rowan )
8. Go search the dwarven mines and retrive axe of stone and letter)
9. Confront mayor
10. I gave all my items to the king thereafter
11. Talk to the released elf.
i am not sure about 10 though,i found that the king wouldnt start the dragon armour quest if i didnt give him the letter and /or axe
