Ray_of_Light,
The level 1 current draw of 1.65A (presumably at 3V) is way higher than the power supply was designed for and should be considered a defective light. The power supply worked quite well at 2.5W and was rapidly dropping in efficiency by the time it reaches 3.5W and hit the point of no useful additional output soon thereafter.
This indicates you have a poorer quality LED in the flashlight.
The most likely cause of the flickering is an instability in the voltage sensing and compensation circuit. There are a couple of different causes for this but one is a hardware problem that changes the time constant of the control loop and makes it unstable. In any case, the problem cannot be fixed.
Although the term flicker does not describe the situation very well, the light should not "flicker" on level 1. That said, there is a situation which is normal and which can appear to be a low amplitude (visible but not a large change in brightness) and low frequency flicker. If the battery voltage is changing (dropping) rapidly, the output power can change from moment-to-moment and due to rounding errors, the light will get slightly brighter and than a few moments later get slightly dimmer - emphasis on slightly. If that is what you are seeing, that is normal. Otherwise not.
Henry.