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.