Conflict of Interest in Refereeing

A young referee for a physics journal is coincidentally working on the same problem that appears in a paper he is sent to review. He gives a positive review of the paper, and then goes on to publish his own paper on the subject. When the original author becomes aware of this, he complains to the journal. When the editor approaches the referee, he pleads with the editor to not contact his home institution, and apologizes profusely? How should the journal editor have handled this situation?