Here's my own interpretation:
Sir Sarles is a conceited snot who doesn't deserve to be hired by any Good temple. He makes no distinction between the various faiths, and he doesn't consider it an honor to serve any of them. He refuses to be employed unless you put him on a pedestal and provide him with the means to glorify himself (instead of your deity). He will work for you only if you can provide him with "the medium of his choice", and that's the only reason he has any interest in working for you at all. If the material he desires were readily available, it wouldn't be so bad, but he knows darn good and well that the quantity he's demanding is completely unreasonable, given its limited availability. If you were to comply with his demands, you couldn't be sure that he wouldn't think of some other reason to get all huffy and refuse to finish the job. He's a pain the rear, and the results wouldn't be worth the trouble, since his heart is in the wrong place.
If you're a Cleric of Lathander, you should follow the orders of your superior, and you shouldn't lie to Sir Sarles. But you shouldn't lose sight of the true goal of the assignment. You're doing it for the glory of Lathander, not for the glory of Sir Sarles. Any person with good sense can see that excessively pandering to Sir Sarles would corrupt the spirit of the project. To push the project in the right direction, you should try to persuade Sir Sarles that he should approach the task with humility and a true heart. He'll tell you to get stuffed, of course, and you should take that as a big hint that the project is bound to be a disaster.
Given that supposition, you should cooperate with Sir Sarles and try to help him in his efforts to glorify himself, but there isn't any need to bend over backwards. As the ore merchant will tell you, Sir Sarles himself can't tell the difference between real illithium and an alloy. So why not offer him the alloy? It might not be the very best you can do, but you did have to go to extraordinary lengths to acquire it, and it's a lot better than anything that anyone else can offer him. Look at the dialogue options carefully. You don't have to lie to him to offer him the substitute for illithium. The ore merchant assured you that it would be an acceptable substitute, and it was the only thing available on the common market. If he throws it back in your face, then he's just being unreasonable.
Go back to your superior and explain how unreasonable Sir Sarles really was. You don't have to lie, and you don't have to be ashamed of what you did. Have faith in Lathander. When your own heart is true, things will turn out for the best.
