The teddy bear should be in the hallway just outside Janus' room, in the north west corner. That is the last quest you need to do in the castle, so make sure you complete everything else and finish looting before turning it over. Also, you may want to stash any unnecessary loot in a chest and toss it out the front gate to get later.
Returning the teddy bear will result in you leaving the castle.
After the castle, and going through a detour, you will meet Arhu the cat again, who will give you a quest to rescue Zandalor.
