This:

WARNING: Found User-Password == "...".
WARNING: Are you sure you don't mean Cleartext-Password?
WARNING: See "man rlm_pap" for more information.
[files] users: Matched entry DEFAULT at line 2
++[files] returns ok

Causes this:

[mschapv2] +- entering group MS-CHAP {...}
[mschap] No Cleartext-Password configured.  Cannot create LM-Password.
[mschap] No Cleartext-Password configured.  Cannot create NT-Password.
[mschap] Told to do MS-CHAPv2 for john with NT-Password
[mschap] FAILED: No NT/LM-Password.  Cannot perform authentication.
[mschap] FAILED: MS-CHAP2-Response is incorrect
++[mschap] returns reject

Fix the first error. Entries in the users file should read:

username        Cleartext-Password := "thepassword"

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