I don't see the issue. The basic proposition is that:
A. Some crimes (actually, it's a rather long list if you go by ancient standards) deserve death. (And the NPC in question is known to be guilty of them). Therefore, execution is the default option.
B. A character may legitimately grant mercy to a villain who shows some willingness to make restitution (by willingly helping to oppose the evil he served).
or (and I think that this is where you are having the difficulty)
C. A character may legitimately impose a lesser penalty than is justified (as per A) if imposing the lesser penalty enables him to gain information that will enable him to save lives or bring to justice villains who could not otherwise be safely brought to justice.
It's basically the same logic that RL prosecutors use to justify plea bargains, reduced sentences, and/or immunity in return for testimony. I can see some hyper-lawful characters who think that full retribution must be visited on every villain no matter what might object to the concept, but it certainly doesn't seem beyond the pale for any lawful good character. (And, I must say, my cleric has neither the law nor the good domain and has not consistently been lawful (he's more lawful than neutral though)).
As to whether it amounts to a threat "do what I want or I kill you", I suppose it could be boiled down to that level. (Although "I plan on killing you but might change my mind given sufficient reason" might be a better formulation). However, I think that the moral quality of the threat is very much changed if the person making it has the right to do what he threatens to do. To use a different example, I would be wrong to tell someone "give me my money or I'll beat you up" because I have no legitimate right to beat you up. On the other hand, if I were to say "If you insist on selling X, Y, Z, I will boycott your store and urge others to do likewise," I am threatening action that is within my legitimate rights. Boycotting someone is not nice, but nice is not the same thing as good and there's nothing inherently wrong with threatening a boycott. The moral quality of the boycott threat would depend upon the moral quality of the course of action demanded. (Boycott because someone is exploiting desperate workers=good; boycott because someone won't cover up your dirty dealings=bad). So, if you insist on boiling it down to that level, there's nothing inherently wrong with threats.
Kahuna Burger said:

I'm not usually an alignment stickler, but I don't see it. If you kill someone because they don't help you, its not good. If you free someone who deserved punishement because they did you one favor, its not lawful... If I were your DM, you would probably lose one of your domains - I can possibly reconcile this with one or another but not both... especially not domain level allignment loyalty.
I was doubly shocked to hear that more than one LG cleric considered this an acceptable tactic.
Kahuna Burger