Maybe very small demons could be caught in glass bottles and suspended from the ceiling in order to give light in the Labyrinth.
Why is having fools trying to slay dragons a bad thing? Isn't that the basis of many a story?
Don't drink the holy-water; we don't like it when you drink the holy-water.
Hmm. OK. How about this: Dragon breath transforms things, burning them from their original state into lizards or fruit or trees. Pyromancers have discovered the secret of dragon fire, and use it to power the mills, manipulating the conditions of the flame to make it produce whatever is needed, sacrificing memories to feed the islanders.
(Addendum - it is very early in the morning here, and I am very tired, so I'm not sure how much sense that made.)
Also, I think the idea of an outbreak of paladins is funny.
Junk doesn't pile up on the islands much - mostly, there are abandoned buildings and machines, rather than sprawling junkyards (though some do still exist).
Removing the sprawling junkyard weakens the image for me. If it's mostly just abandon buildings and machines that are lying around the Islands, then the setting feels much more generic; it feels much more like every setting where ancient magical devices and mystical ruins dot the landscape in every direction. Nifflas needs to be a trash heap through and through.
Finally, don't add too many quirky details, Mostly Ghostly. The gimmicky stuff that's in the setting now is great because it moves beyond the gimmicky and makes for a really compelling, creepy, unimaginable whole. But if you add too many little ideas, the setting gets glutted. I already feel this way about a couple of things in the setting. The edible 'Sweepings of the Divine Plate' hiding among the junk and the Storm-born only get referenced once, as far as I can remember, and they don't seem to fit into the whole very well. There aren't any other references to storms or weather carrying intrinsic power or changing things, and I don't think there should be. We don't need another "source of power and change" to make sense of; we can hardly handle the ones we have! I say scrap the Storm-born.
On that note how many mills do we want to give explicit page service too, we have four currently:
-Mill of names
-Mill of corpses
-The third Mill (in the Day)
-The Forgotten Mill (Unknown location, eats hope)