Do you have the letter on you when you talk to the dwarven king? You need to toss it into the throne room and pick it up after entering, or toss a teleporter stone in to bypass the guards that take your stuff (or kill them using Poison Cloud, or something, cast near but not directly on them, to do damage without turning them hostile or resulting in a reputation drop).
IIRC the dwarven council member can take the letter and axe if you talk to him first.