The plugin ignores the html part of the message stanza. It decrypts the body tag (which is text/plain per definition) and displays it without further formatting.
The pidgin-otr plugin is known to encrypt the text/html message and put the ciphertext in the body tag, which is probably a bug.
I have the same issue with contacts that use pidgin and adium clients.
Documentation says that encrypted message may contain HTML markup
http://www.cypherpunks.ca/otr/Protocol-v2-3.1.0.html
"The plaintext message (either before encryption, or after decryption) consists of a human-readable message (encoded in UTF-8, optionally with HTML markup)"
pidgin-otr is something like a reference implementation of OTR. At least it is available from the official OTR site.
Corresponding adium bug:
http://trac.adium.im/ticket/6901
"Adium's behavior here is correct: OTR messages have to be encoded with UTF-8 and may contain HTML markup. If other clients show these tags literally, then those clients need to be fixed."
I've updated to latest git version. It seems that now otr plugin "eats" newline characters in incoming messages. It is probably an incorrect processing of "\<br />" tag