I don't have a lot of experience with open mikes, but you're right, this DOES seem like weird etiquette. Ordinarily I would call it rude to play along without asking, but if it's true that this guy is a great player, and he sounded good, then I would cut him some slack. I would also cut him some slack due to the fact that his playing along seems to be an established local custom. Weird local customs do spring up from time to time, and usually should be respected.

(That reminds me: I should describe how the "reserved seating" system used to work at the now-defunct Coffeehouse Extemporé in Minneapolis. Now THAT was weird. Maybe I'll start a separate thread on that someday.)

I'd say you handled it exactly right. If you prefer to sing without accompaniment, you should feel free to say so. Just say it politely. It sounds like that's what you did.