Correctly place the commas around the non-essential clause:

The placement of commas around a non-essential clause is determined by whether the clause provides extra information that can be removed without changing the main message of the sentence. In this case, the phrase "even though the villagers denied it" is a non-essential clause because it adds supplementary information about the dragon without altering the primary meaning of the sentence.

In the first choice, the commas are positioned correctly: one comma comes before "even though" and the other comma comes after "it," effectively setting off the non-essential clause. This indicates that the sentence can stand alone without that part, making it clear that the main subject is "The dragon was actually a nice guy."

The other choices incorrectly place the commas, which disrupt the flow and clarity of the sentence. For example, the second option includes a comma that separates "even though" from the rest of the clause inappropriately, while the third choice incorrectly segments the phrase "even though" from the rest of the sentence. Thus, the first option is the clear and grammatically correct choice for properly using commas around a non-essential clause.