Becca, I know this whole thing is irritating and annoying to you on a personal level - however, I really think you need to leave LJ out of this, and address the Dreamhost/domain name/blackmail part of the email. As a fannish type who's been on LJ for six years, I understand how complicated LJ/flist drama can be - however, by continuing to discuss the "he said/she said" of the flist drama, your claim of blackmail/harassment is getting lost in what is essentially BNL fandom wank.
Don't stoop to their level. Don't dignify their behaviour with a lengthy reply - in my experience, people like that never bother to read your carefully-crafted response, anyway. Simply state, calmly:
1. that the threat they have made is, indeed blackmail, and that blackmail is illegal;
2. not only will you not acquiesce with their demands, if any further threats or demands are made, you will contact a lawyer;
3. and ask them to name their price for purchasing the domain from you.
Remember, just as you're keeping records and copies of what they've said, they're likely doing the same to you. In the (admittedly very unlikely) case that this matter is turned over to law enforcement, you will have a much stronger leg to stand on if you've kept cool and haven't played their game.