Hey, we have another winner for what to do with prisoners.
The last time, you misssed that the ethical problem with prisonners is "killing them or not?", not "what do we do with the bodies?" when considering the ethics of cannibalism.
Any time we're outside of town, we believe that we are entering the "dream land" and nothing we do is evil. Burn down that orphanage? No problem, they're not real.
Granted, that means that we're insane, but, hey, we're not evil right? And, well, there's nothing negative about depicting an entire race as insane is there?
1. If an adventurer is saying that he thinks he's only in a dream to avoid the blame when killing people right and left, then it would be Evil in D&D and morally wrong in the real life. He's not escaping out of the prisonner problem this easily.
2. If he is, as you state in the second part of your argument, insane and really think your excursions outside of town are just dreams, of course he's not Evil in D&D (he'd be unaligned, as he's unable to make a moral choice on his actions) and of course he wouldn't be guilty of anything in real life. Being truely insane on the scope you describe prevents penal prosecution (insert usual bike theft disclaimer).
3. Never in the description it is claimed that they believe they are in a dream. They consider what happens on the surface to be guilt-free, as if it was a dreamworld. It's not the same (no mental illness, just a societal view that what happens in
Vegas surface stays in
Vegas surface). Does this cultural approach change anything with regard to their alignment? No, because D&D alignement isn't subjective. So they can't escape being evil-aligned if they are behaving contrary to the objective moral laws, which apply equally whether one considers the surface world to matter or not. And yet, they are neutral, not evil. Despite considering that what happens on the surface doesn't matter, they are not murderous psychopath, they are, as described, peaceful and serene as long as they are left alone. They only rage against trespassers, which is OK in D&D morality system.
4. A point could be made that many (most?) adventurers, who don't have a dilemma with prisonners (I am glad your group has this dilemma as part of their game but I think the solutions you put forward wouldn't fly with my group) and will kill evil bandits who attack a caravan without problem, are effectively acting as you describe: they consider that what happens outside town doesn't really matter and have no guilt when killing other sentient being. It doesn't mean they will suddently slaughter the traders and feast on their entrails, but in most adventuring groups, there is no real sense of guilt accrued when killing bandits.