The problem is that the version of telnetd you use can not
negotiate out of binary mode and actually has several other
subtle bugs in telnet option negotiation.  I would
recommend getting a newer version of the telnetd code from
somewhere, but as a stop-gap adding the following line of
code to the end of wontoption() in state.c will fix the
problem we are encountering:

set_his_state_wont(option);