Wiki:
A Mad Wizard
As stated above, that's the designed outcome. Getting seen with the thief costs you 40 rep, so returning the item (or paying him off) only brings you back to neutral. So, you end up getting more Rep for the Seventh House for fighting the werewolf than you do for the Wizard's Guild.
Yeah, we know. The Developer is kind of a jerk with this quest. Do everything right, and you come out neutral. Mess something up and you end up way in the hole. Not really a winning situation. I blame Adaon. Little bastard.