Quest item stuck

Killing Fairgraves removes the Allflame from your inventory. If you still have it, then you haven't killed him (in theory). Perhaps you died and were in town when Fairgraves was killed? Has Bestel rewarded you with a passive skill point for it?

Try going back to the Ship Graveyard (in a fresh instance) and see if Fairgraves is there for you.

If you somehow do have Bestel's reward already, you can just go outside of town, drop the Allflame and leave it behind.