Day 2 hasn't been the most productive for me but I've still managed to get a few critical things.
Bugs have been squashed and I've got the neutral and hostile AI's working properly after a few mishaps. The plan is that town guards will see through your disguise if they get close enough to you and attack you, so you need to be careful to avoid them as you slink through the town. The ordinary townsfolk don't care about you unless things get ugly and then they might get involved. I've gone the full gamut of AI problems - guards turning hostile and then attacking themselves, being attacked by townsfolk while they stand there, attacking townsfolk for no reason, and now finally it's working properly.
Next step is to work on the spread of alarm through the town. When someone sees someone else who is alarmed, then they'll also turn hostile. It's supposed to mimic the spread of your description through the population once your cover is blown.
EDIT: And that work has been largely done. What you can see below is a scenario where the player has been exposed and alarm has spread through the immediate area but the rest of the town remains unaware.