Newbie confused about pg_hba/md5 and password field in PQsetdbLogin

Hello,
I'm pretty new to PostgreSQL in general and even newer to libpq.  I am 
trying to get a C program working (the authpgsql module in courier-imap) 
that uses PQsetdbLogin().  I've got 7.2.1 installed and running and have 
had no problem accessing it via JDBC.  I have encrypted passwords in 
pg_shadow and have "md5" set for the AUTH_TYPE in pg_hba.conf.  However, 
when using PQsetdbLogin the only way I could get a login to work was to 
use unencrypted passwords in pg_shadow and change pg_hba.conf to use 
"password" instead of "md5" for the database I want access to through 
authpgsql.

Why is this?  Do I somehow have to md5 the clear text password before 
calling PQsetdbLogin()?  Does PQconnectdb() handle this and I should 
update the code?  I feel that the client code should be unaware of the 
over the wire encryption method used and the encryption method of the 
password in pg_shadow but I may be way off base on the underlying issue.

Thanks in advance for any information.