The Ancients knew that all librarians were helpful to Mike, and thus ordered Rita killed since she was a librarian.
So, why did Mike blank out and have Laser-Guided Amnesia? Either this is a side-effect of formerly having the embryo in his head, or Jack simply knocked him out before killing Rita.
Because the embryo was planted in Mike, it has a special connection to him. It is possible that the pills that were supposed to destroy the embryo instead merely banished it, and it was able to grow afterwards.
The events of the first game were actually Mike having a stroke or some other mental problem, possibly caused by his new house. The house may have also simply been full of hallucinogenic mold/fungi. The reason why the librarian felt compelled to give Mike the pills was because she noticed him looking like he badly needed them as he wandered around town.
This requires an explanation of why Jack would continue to talk about the Ancients after Mike has perished. Well, dying from stabbing can actually take a while depending on where the stabbing happens, so Mike may simply be having a Dying Dream of Jack saying those things and riding off.
The Keeper really was the Shapeshifter all along, and Mike was only hallucinating that she had a connection with the librarian. In reality, Mike has always been evil and therefore his dark world counterpart will be likewise.
Alternatively, because Mike has multiple personality disorder, he may have multiple dark world selves, of which Jack is one.
Alternatively alternatively, Mike does have multiple personalities, which is why his Dark World counterpart is the Shapeshifter, who has multiple appearances.
- Alternately: The Dark World is real, Jack is the shapeshifter and Mike is as good a guy as he can be, but he's still crazy. The events of the first game damaged his mind.
Except maybe for Mike Dawson's fate. I mean, many of the events of the late game seem unrealistic. The strong man actually liking Mike? That's a big clue right there.
- He does wake up in the therapist's office at the end.
Jack is just a guy who is really good at sneaking.
While Mike extracted the embryo, its insertion still left permanent brain damage. That, combined with the massive trauma of the events of the first game would be an excellent recipe for crazy. This also explains the huge shift in characterization between games.
Depending on how well the player does, he's very likely to still have a few "extra lives" at the end. Surely he can redeem them in whatever our world's afterlife is like, too...
Hated by nearly everybody? Check. Has only one friend that turns out not to be? Check. Poor relationship with parental figure? Check. Whiny, annoying, and wimpy? Check. Both protagonists in a piece of Mind Screw? Check. He's pretty much Shinji as a white guy.
After the events of Dark Seed II, Mike wanted to become a detective. He couldn't, because everyone in the town was either dead or hated him. So, he faked his death and fled to Canada under an assumed name (which we never learn) to become one. It would explain why the protagonist in that game appears to exhibit Dawson-like competence and charisma, and why (s)he wastes time instead of focusing on the matter at hand.
Mike is mentioned as being a writer. It's possible that he wrote about his experience in the first game, but took a few liberties to make himself look better. That's why his characterization is so radically different in the second game. Mike actually is the whiny Manchild he is depicted as in the sequel, but of course he wouldn't see himself that way so he changes some things and whitewashes his behavior. The first game shows what happened from Mike's point of view, while the second game shows events from an outsider's point of view.
Perhaps as a way to warn everyone about the Ancients and the danger they presented. The sharp drop in competence between games was the result of Mike trying too hard to avoid making his author avatar an obnoxious Gary Stu (or perhaps to demonstrate how not to deal with the Ancients).