There really are no wrong & right answers here. Here are my thoughts...
On the Nature of Free Will
Consider for a moment that all morality is habit, and those socially acceptable deeply ingrained habits constitue a "charitable and pious woman" or a "good husband." Those habits which are borderline unacceptable are termed obsessive (as in OCD). A Sufi, a Toltec, or another mystic/gnostic would say we're all infected by a parasite. We think we have free will, but what we have is free will in a box. You can take certain actions, but there are actions that you cannot take. There is too much inertia to overcome, and thus you are trapped in your bad habit. It might be obvious like repeating a trauma inflicted on you, like shameful acts of violence. Or it might be subtle like failing to honor a parent for the sacrifices they made for you, or buying and using a product which relies on slave labor and is environmentally toxic. Thus enters spiritual practice - meditation, whirling, chanting, prayer, fasting, vision quests. These practices break apart crystallized habits and increase the size of one's freedom box. And for developed souls, their spiritual practice merges with their every day life so that they are continuously breaking their habits to become more authentic, more free. Eventually, you find true liberation and become the master of your own destiny.
Free Will for Fiends 101
Fiends have developed some very bad habits which were a long time in the making. Do they have free will? Sure, but their box of free will would seem like a tiny cage for a mortal. You eat to excess every day of your life and then you decide to fast one day. Guess what? You're going to have one hell of a ride as your body and mind adapt. It would be much easier if you had been fasting a little bit all along. You think of one side as the enemy all your life - it's been indoctrinated into you, you've killed them and seen them kill your friends - and then a peace treaty is declared. Is it any surprise that if no effort is made to help you come to your own separate peace that you might snap on someone because of their ethnicity? How much harder is it going to be for a fiend?
Re-Education
Like a wicked or crazed man, re-educating a fiend is hard work. Even if they want to seek good, they've got all this inertia of ingrained wicked habits to overcome. They'll need a rock solid, fluid spiritual master with time to devote to reforming the fiend and the fiend will need to unerringly perform its spiritual practice. Day by day its capacity for free will grows. It would be truly a miracle if it attained an average human-sized freedom box.
See this doesnt really sit well with me. I can see a spirit being taking on a solid body, but "solid spirit" doesnt make sense to me.
Maybe this was one of the reasons the fiends fell? For professing physical matter as equal to spiritual matter, or as being essentially the same thing. Perhaps the fiends argued something like: "There is no higher realm than flesh and earth. You say this is my body, but I say it is my spirit. When I have pleasure through sex, wine, drugs, or a breeze in my hair that is my spirit singing. When I perform austerities or deny my impulses then do I offend and deny my spirit."
And then God said:
Oh yeah? *SMITE!*
The Reproduction of Fiends & Celestials
Reproduction = the act of creation and ensuring a lineage that carries your values. An outsider is moral philosophy made incarnate, thus any act of physical creation is equated to an act of philosophical creation - a spin-off or a more refined concept, perhaps even a heresy unallowed by the former philosophy. Why breed with a mortal? Because the offspring's free will box will be vastly greater, thereby producing the possibility for a better future (for celestials), or an even greater fall (for fiends).
If they cant breed with one another, how are there so many of them? The problem from my perspective remains the same tho: the concept of concious beings that are "born" evil.
Well, the Catholic Church espouses the concept of original sin. While babies are not evil, they are certainly sinful according to a Catholic. And pretty much everyone agrees that babies are conscious during their birth (just ask anyone who has been rebirthed or who works as a midwife or doula). What if the child is born with a subtle brain damage that prevents him from feeling the impact his actions have on others; this would be very similar to forms of autism or asperger's. Now if the parents raise him to do good and work with his condition he can learn to feel responsibility, appropriate guilt, compassion, and mercy. If his parents are fiends however, they'll teach him to be a mean SOB. Thus a dysfunction of the brain + bad training = what we call "evil."
But, are outsiders conscious?
It seems like a silly question. Of course they are. They can talk, make deals, and lament their fate - of course they're conscious! If you look deeper: Let's define consciousness as
having awareness of one's environment and one's own existence, sensations, and thoughts. (one definition from American Heritage).
* Outsiders certainly seem to have awareness of their environment, right? When a fiend sees a murder what do they see? When a celestial enters hell or a place tainted with many evils what do they see? Perhaps they have limited awareness or are hyper-aware.
* Are outsiders aware of their individual existence? That seems certain for the fiends; it's almost a prerequisite of falling. For some celestials, especially those closest to God, I'd imagine the situation gets fuzzier.
* Is an outsider aware of her sensations? As outsiders are philosophies made manifest, and they do have physical bodies then they at least have some level of sensation. It is likely that fiends may be shielded from the emotional impact of some of the atrocities they commit. Perhaps even certain celestials too (from the evils of the fiends that is).
* And is an outsider aware of her thoughts? I'll leave this one to the scholars...
A Fairy Steals a Fiendish Babe
So what if a fiend's child is stolen and raised with a different set of morals? What if the babe is trained by someone who is considerate, loving, and deeply passionate? The babe is raised deeply in touch with its feelings. When the young boy slights someone he feels pangs of guilt and wishes to reconcile. When he helps another he feels deep pride. He has developed a moral compass which his fiendish parents lack, and he can now feel good from bad. A fiend on the other hand, only intellectually understands good from bad (and has a very sharp understanding too).
Well, the only trouble I have with the fiends as former petioners idea is it doesnt work very well in a cosmology where evil mortals are supposed to suffer eternal punishment. Being granted all that power is more like a reward.
Unless it's more like possession and you're watching yourself committing all these hideous deeds and there's nothing you can do to stop it. That would be pretty hellish. Sure you can toss fireballs and shrug off swords, but you can't rescue the nuns or horses from a burning convent, and you've got to watch as you set up people you once called friends to turn against each other. I'd imagine that the true psychopaths wouldn't be turned into fiends, at least not until they were trained to feel guilt...
The moral of the story? Be good. Smite fiends. 
