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I have to admit, this is a tough concept for me, I've fudged the area arachne pointed out above, and I'd like your opinions on how I'm doing, and if I'm correcting the jaggies and the banding problem correctly. If not, I need more help, otherwise, I can start working on the rest of him.
the way I'm looking at the problem is more like if we have 3 colors, a light, medium and dark, the dark and the light can't touch, except for the corners, and you have to bridge the colors using the medium color. Problem with this is that i feel like I've seen a lot of good pixel art where you have a really bright highlight, and to 1 side you have smooth blending, but to the other side you have the darkest color in the palette. I'm not sure if this is a lighting thing, a style thing, or what, if anyone knows, please let me know

Thanks

EDIT: added dragon10.gif next to it, for ease of comparison.