I like this. It's interesting, although some of the plot holes are patched up rather weakly. I'll take a stab at it, along with some other thoughts.
I don't like this very much. I think a prison would keep the prisoner from influencing others to free them. A better solution imo would be something along the lines that the island is inhabited by dangerous rahi that were meant to act as guards for the prison (Maxilos Robots?). These guards would only patrol the deeper island near the prison, but since a majority of the valuable resources were located there, many matoran would leave or die trying to collect them. Over time Matoran would leave as they realized they couldn't safely reach the resources. These Guards may later be killed by the sinking of the island, allowing the Matoran who stayed the ability to get those resources, but not be able to really profit off of them.
How about we merge the G1 and G3 ideas? I say he owns his own kingdom, but he's manipulated by Takadox to do his bidding so in the end many simply see him as Takadox's puppet. Further adding to the reasons to disrespect him.
Really don't like this. way to Dues Ex Machina. I say that we go with the idea that the Barraki are serving Karzahni, and Karzahni changes their form to suit their environment, but can't make them amphibious due to the magic chains explained in the next segment.
Now, since the Shape Changing material plot device was removed, I have a proposition to fix this reopened plot hole. Karzanhi would be entrapped by magic chains that shifted with his form and reduced his powers, and would keep him from escaping through the opened holes. It would also limit his power to influence the minds of the matoran, so only the matoran who go into the cave would be affected.
AKA Spinax, right?