Simon--I'm pretty sure once you're in NPC mode you have to go to the TRADE menu and give him some items before you fight. This should allow you to take all the goodies at the end.
As far as Greater Demons go...yeah, all the really rare weapons & stuff come from them and the Pit Fiends (which you fight if you choose the other door in the Temple). Among the good stuff I've gotten:
Excaliber (4d8 4, 4 to hit, 2-handed)
Diamond Eyes (3d4 4, 3 to hit, *great* secondary weapon)
Zatoichi Bo (3d6 6, 3 to hit, best extended weapon)
Glass Slippers (-8 feet, 99% mental resistance, women only)
Cape of Hi-Zen (for monks, -3 special armor, 1 regen)
I've also seen repeats of a few items from the Hall of the Dead (Muramasa Blade, Maenad's Lance, etc.) Had to fight a *lot* of battles to see all this stuff, and never found a real pattern for when it comes up. What I did was build my chars up to a level where they could just hack their way thru any battle (practically just holding down the enter key the whole time to have everyone Fight) and turning all sound and delays off. That way I could fight a battle, quit/nosave and re-fight without wasting more than 30 seconds or so. Good luck!