I am shocked that a paladin would behave in such a manner. Don't you just hate it when you have those darned characters all high and mighty knocking off those secret significant plot elements?
All silliness aside, from what you've indicated, this was for the most part your garden variety paladin (5th level). I'll cover the whole issue of alignment in a moment. In many instances there are prestige classes that allow paladins to go willy nilly smiting the slightest hint of evil without complications. Paladins often wind up in situations that hamstring the rest of the adventuring party if the paladin does not act appropriately. Roleplaying a paladin is one of the easiest yet most complicated characters to do justice. (No direct pun intended.)
Having stated the obvious, if the perpetrator was doing evil, the paladin must act without hesitation. According to my understanding of a paladin, a great deal of tutelage and training is doted on the paladin by the elders of the diety that they worship. Certain villainy requires to be dealt with harsh and promptly. The paladin has been taught to judge situations when they arise and take action. Stepping away from that for a moment. The conniving DM placed the paladin in a morality situation that required him to do the "right thing" regardless of the outcome. The complication is that the DM decides whether or not the player's interpretation of what a paladin does in that situation is appropriate.
The key alignment aspect is Lawful in this issue. Following the guidlines of order. Clearly something lawful was violated. Now here is where the problem lies. Good vs. Neutral vs. Evil. Slaying the evil-doer as it relates to the circumstance is vague. Walking into that situation blindly as the paladin did meant that so much was unclear. Did the paladin detect evil? Did the paladin cast detect alignment? Was an iniative roll used to determine whether or not the paladin could act first? If the paladin caught the peasant flat-footed and had a free action before an actual combat would initiate, it seems the paladin chose the tried-and-true: strike-first-and-ask-questions-later. The player's actions could be related to how the DM has ambushed his players in the past.
Paladins following a code strictly is a bland way to role play a character. How often have you been in a game where the party wastes twenty minutes hemming and hawing over what to do? More often than not all the parties efforts make no difference because no matter what, the DM will have his way win out. Removing that which makes a paladin from the character in this situation seems too harsh. The character's alignment may have been played inappropriately. As a result the DM is within his bounds to say that the paladin's alignment is being played ie. Lawful Neutral opposed to Lawful Good and the player must now adjust the character accordingly. At the same time, the opportunity for the character to atone for this has to be there.
So Sayeth The Bone Daddy!