Step 1: Find dude. Dude is blue. Step 2: Run to Watch House and take quest with one other guy. Step 3: Go find dude again. At this point, dude is still blue. Step 4: Kill dude. Dude is now red, obviously. Step 5: Loot dude. Step 6: Turn in quest. 500 gold, and notice saying we were not part of the quest and would not receive XP.

Dude's name was Xygax Firefist.

Can confirm this with two more incidents exactly the same as sexysuit mentions.

The faction and XP issue both go way back to the creation of the quest. While the XP issue is persistent, the faction issue is not, and I've encountered very strange bugs when it comes to that (faction "flickering"). Usually, however, the factions tend to work as intended (but it's possible something got borked recently).

But Thrawn has been so busy. :(