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I'm not sure how the difficulty level is implemented. I believe it affects the frequency of random monster encounters, and in other games, it has increased the HP of the monsters you face. I'm not sure that happens in W&W.
And I agree with Wyvern - I don't think it would take affect for that encounter.
If you can't leave town, then I suspect you're running into the XP virtualdub issue. Check the Tech Tips thread for details... decompressing the .avi files seems to take care of it.
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*B*
Save Early, Save Often Save Before, Save After
Two-Star General, Spelling Soldiers
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Give 'em a hug one more time. It might be the last.
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