Off the topic I haven't been to that actual town, but I have been to Perth area a few times and I have toured some of the vinyards north of Perth, and I too really like the area.
Anyway,
I hate to see someone caught in the situation that you are in especially since you have had good intentions from the start. They are trying to make you look like the bad guy. You seem like a reasonable person, and their request is very rude and unprecidented. I see that you have two options. Since this is a site related to their business, and I have already heard the word lawyer, then there is the potentintial for a trademark case, but your not to that point yet. As far as the domain is concerned, there aren't a lot of links coming into it so it wouldn't be a huge loss as far as search engines are concerned. If it were my site, and I get really mad when people trying to scare me into giving them a domain before they have reasonably tried to obtain it from me, I would drop the domain, Fill it with useless content and get a new domain for my own site which I would endlessly promote, so that they cant have that domain either, just due to the fact that they threatened me, or I would offer it to them at some rediculous price.
It really comes down to they want the domain and are going to try to scare you into giving it to them instead of aproaching you like a person from the start and trying to work something out with you.
Personally I wouldn't give it up..
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