Thank you Mariano for reminding us on the uni/puny-code things.

Yes, fred(client) can create_domain xn--mund-4na.fo and more or less anything else, given 'allow_idn = true' in /etc/fred/server.conf, all over EPP, and it goes into the zone file without problems. Even 'ámund.fo' works as expected in both whois interfaces. This is great news around here. :-)
  Our expectation was that it would be possible to create domain  'ámund.fo', but this just returns a 'bad format of fqdn domain'. I guess we will have to adjust our expectations, and just live with the xn-*.fo domains in lists and such.

This leaves us with the original request which is that we just wanted to accept a few non-ASCII chars, not the whole UTF8 chebang thing. I guess we would need to filter user input somehow allowing for a few extra chars. Is this there currently a solution for this ?

And now for something completely different, but related - which might be considered a bug:
  It seems that in order to register a idn name the registrar has to be a 'system registrar'.
Here is what we get, while being a 'non-system registrar' trying to create the domain xn-1ca0d.fo

> create_domain xn--1ca0d.fo TZ01
Do you really want to send this command to the server? (y/N): y
Return code:              2005
Reason:                   Parameter value syntax error

ERROR: Element that caused a server error condition: <domain:name xmlns:domain='http://www.nic.cz/xml/epp/domain-1.4'>xn--1ca0d.fo</domain:name>
Reason: bad format of fqdn domain

Now we changed the status of the registrar to 'system registrar' and tried again:

> create_domain xn--1ca0d.fo TZ01
Do you really want to send this command to the server? (y/N): y
Return code:              1000
Reason:                   Command completed successfully

Domain name:              xn--1ca0d.fo
Created on:               2017-01-03T18:15:43Z
Expiration date:          2018-01-03


We would expect that others than 'system registrars' should be able to register idn names, right ?

Btw: /etc/fred/server.conf contains the following two changed idn and epp settings (as we are still working on getting epp charging to work, but that's for another day )
allow_idn = true
epp_operations_charging = true