If you do kill everyone, chances are your reputation will drop.

If you got a party of 4, you can split them up and have two do all the butchering while the other two are some where else in town. Keep the two main characters out of the area until your ready to take the head.

Every time there I run into trouble on the road, there is always a dwarf at the bottom of it. Don't they know how to drive above ground?