I tried a LOT of different strategies before finally beating this.
As others have said the most important thing is to build your town to the south east a ways away from your castle and away from the marauding hordes that will eventually end up fighting each other after razing your peasant homes.
Here's how I set it up -
Code:
pppppp
pppppp
C
R M R
r B r
c I c
e S e
p - peasant houses M - market
C - castle B - blacksmith
R - ranger guild I - Inn
r - rogue guild S - statue
c -clerics guild
e - elven bungoblow
Zero towers, as even a row of three dwarven backed by three upgraded will be over run. Paldins will be healed indefinitely and swarms of elves will pick them off one by one.
The strategy is to wipe out the dens in the south and east and secure the trading post ASAP in order to get your heroes enough experience and cash to be able to enter the fray up North. I surrounded the town with 100g fear flags, too - the only reason to intervene up north is when your castle in in danger.
After the dens were gone, I kept a constant defense flag on the north west ranger's guild so that heroes wouldn't wander yet be close enough to pick off stragglers. From there, the point is to slowly whittle down the enemy horde and not let there heroes escape - low level paladins and elves aren't a threat, swarms of high level ones with tons of health potions are.
For this, parties of rogues, rangers, elves and clerics are most effective. Paladins are tough and hard to actually kill, but have low attack and rely on clerics for backup. To this end both rouges and rangers can reduce attack, rangers have arrows that drain cleric's mana, and the combo of tangle and poison ensure that the bastards die. Vs enemy elves and rogues you're fighting fire with fire, but you have the edge with your cleric backup. They're not as much of a threat as paladins anyways, provided you keep their numbers thin.
Once you have all high level enemy heroes killed clear out the northern dens, grab the trading post and bide your time until your heroes are fully upgraded, at which point you can attack the enemy bases easily. you can build temples and a hall of lords too, but you don't need too because at this point you've pretty much won. Maybe a temple of fervus to help against the brutal wizard looking towers.
Also, this is the most difficult and bugged mission by far. Aside from the obvious swarms of enemies hero parties seem to develop bizarre blood feuds at random that they'll charge into enemy kingdoms past rows of towers and fight to the death for. Fear flags don't have any effect at all - disbanding seems to be the only way around this as every member will then instantly flee. The constant crashes are great, too.
Anyway good luck on this terrible, terrible mission :wacko: