The player thought the flag was unjustified and arbitrary. As described, it sounds like the gnome broke the law and flagged him afterwards to either: provide cover for attacking a non-criminal in town, help him kill the duergar with cabal powers, or hinder his escape for revenge.

Whether the flag was IC/OOC/abuse of power/etc. is irrelevant. The point is that *there was no IC way to address the action of the gnome* to even bring matter to someone's attention who could then investigate it, draw any conclusions, and/or apply some remedy, or even just file the complaint away in case it is/becomes a pattern.

If I think a player is acting OOC to abuse game mechanics to his advantage, there HAS to be a way to report that even if nothing is done about it. It's a whole other ballgame to be told that "Sorry, your character has to break role to have this addressed". That leaves the player feeling cheated, not the character.