Yes, killing the hag frees him and the dwarf that has been turned to stone. It should also free the masks in the other room, but I've never been able to interact with them.
Yes, but when you kill the hag in the underground lair, after you have talked with the panicked elf, he is still gloomy afterwards. He is much more positive, when you haven't talked to him before.
I talked to the masks, but they are still confused, they asked me, where auntie Ethel is. When I said, I've killed her, they didn't believe me and continued searching for Ethel.
