Conflict of Interest in Refereeing

Description of the Problem

A young referee claimed to have been coincidentally working on the same problem that appeared in a paper he was sent to review. He made a positive review, and then went on to publish his own paper on the subject. The original author took note, and complained to the journal. When approached, the referee pleaded with the journal that his institution not be contacted, apologized profusely, sometimes tacitly admitting and sometimes denying any guilt.

Questions

What action should the journal in question have taken? Should the editors notify the referee’s institution? What should the author have done to avoid this mess?
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