First of all, I don't have any real problem with anyone turning anyone else in for business matters they aren't tending to. (Not having proper licensing, insurance, paying taxes, etc.). I don't typically go out of my way to do that to anyone. But if I see something egregious and I have some extra time to spend, I might do it.
I'm a big believer that we need to all be operating on a level and fair playing field. Meaning, if I have to get all the licensing, insurance, permits, bond, worker's comp., taxes, etc. than so should all of the other companies I am competing against. If someone is cheating that system, I don't see any problem at all with someone else turning them in. As much as I despise government intervention, if I have to play by the rules, than so should everyone else. So ethically, I feel it's totally justified if you feel you want to turn anyone in. In fact, you almost should do it. For the protection of consumers and to help make it a more fair competitive field for you to work in.
That being said, I'd almost be more concerned with the badmouthing he is doing than anything else. That's not cool at all. If I was really ticked about it and had the time, I might try to get him to come to my house or a friend's house and record the entire conversation. I might give him the opportunity to badmouth by mentioning that I was getting a bid from your company. Then just leave it up to him to bury himself. After the meeting, I might act very interested and see if I could coax him into putting what he said earlier about the company in writing. For instance, send him an email saying, "I wanted to write and let you know we're still trying to decide who to work with. I'm still looking strongly at _____ company. I know you said there were some problems with them. But I don't know. I saw some of their work. It looks pretty good. So it's a toss up right now. What exactly were the problems you saw with their jobs again? I was trying to remember everything you told me when I was talking with my wife just now but couldn't remember it all. Anyway, we're still figuring this out. I'll let you know soon." Something like that would very likely get him to put it in writing. Then you have a recorded conversation AND written correspondence.
With that, I'd get a really good business attorney to send some sort of cease and desist letter, citing the evidence I had against him. Telling him that unless he ceased bad mouthing our company there would be a lawsuit. I actually had to do that recently with a former employee last year. A little different circumstances. He thought he could quit working for us and then go contact all of our customers via email, representing his own company and trying to offer them "Better prices and service than Lewis Landscape". Unfortunately for him, he was on the wrong side of the law. At least in Oregon, that's highly illegal, regardless whether there was any kind of contract preventing this or not. Information like that is protected under the Uniform Trade Secrets Act. At first, my ex-employee responded with a very arrogant reply, saying he was well within his rights and was retaining his own attorney for advice on the matter. But a few days later (presumably after he consulted with his attorney, who told him he was a friggin' idiot for doing this and trying to take on a larger company with plenty of capital to bury him in a lawsuit) he changed his tune completely. Not only did he write the letter saying he would cease and desist, as my attorney demanded. He also apologized profusely and gave back all of the notes and documents he took with him when he left.
It's amazing what the law can do for you sometimes. Anyway, your circumstance is different. But I'd probably try a similar approach. Get him cornered to where he KNOWS you could sue the sh|t out of him. Then send him a strongly worded letter with some demands he has to meet in order to prevent you filing suit. Maybe advise him to consult with his own attorney before replying (which, if his attorney has any sense, he'll tell him to be smart and play ball and never do this again). Then if he doesn't be prepared to actually file suit. Chances are, you will never have to take it that far. But you can't do any of this unless you're serious about following through. In my case, I was dead serious about following through and I would have buried him in a lawsuit. I would have gotten a good judgement and it not only would have probably put him out of business but I'd keep pursuing him personally, if it was legal to do so, until he paid me every last dime from the judgement. The thing is, I had the resources to fight that fight - he didn't. And I knew that.
So that's my advice. Best wishes to you. That freakin' sucks. But it's a good compliment though, if he's that desperate to put you down. You must be pretty good!