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I eventually decided to engage in a battle with the dwarf, though not with my main hero.
Theoretically, he can be defeated fairly by staying in the castle, first destroying the catapult and then casting Confusion on the priests, but it's a long, tedious, and dangerous process, and it gets boring, so I had to resort to other methods.
First, I sent in Arantir; I didn't summon an avatar because there wasn't a killing blow available, but with his 14 ghosts, he took out 250 Arcane Dragons and 70 Fire Elementals. Then, I maneuvered the dwarf into the desired position, and he stopped being a nuisance. I attacked again, more modestly, but after 10 sorties, I took the Crown.
I did well with the Underground faction, but Red is still better. Before taking the tent, you can dismiss everyone except one warrior, encounter a berserk hero with that warrior, and, by reducing his health to zero, take all the artifacts. However, with Yellow, I had to dismiss a hero with the Mage's Hat.
So, the ideal strategy for this is to use mages with a super skill and 14 ghosts (and fight to the last).
It seems that you can transfer Necromancy from the main hero to a mentor, and perhaps, if you transfer everything and take the Mage skill first, you can get a super skill, but I decided not to bother – gold is a problem, after all.
I took the third city; I'll finish the game when I have time, and I'll eventually kill the dwarf