The way I see it, Jyg was cursed to have a split personality-- one that worked completely contrary to his base desires and function. Sort of like a Jeckyll and Hyde thing, where you'd spend hours chatting up saucy Victorian women during the day, only to find that your other self was strangling your dates at night. Very frustrating. Of course, the other personality (Sheogorath) was a real personality, so he wasn't too keen on having his other self wipe out his realm every era. Just as Jyg must've been upset every time he woke up and found weird trees and madmen all over the place.
When the Greymarch began the land was in transition (and by extension the Prince(s)), being neither Sheo nor Jygg but a bit of both. When you reforged the staff from the remaining madness in the Isles, you became that madness, thereby preserving the mad persona of Sheogorath within yourself and freeing Jyg from his curse.
As to why Jyg didn't continue the Greymarch and wipe out the Isles... Best I can figure is that he either didn't want to destroy something that had once been part of himself, or maybe he recognized that this former mortal had just done him an enormous favor. Mankar Cameran was not a Daedric Prince, but he had his own Realm. Perhaps if I hadn't smashed his head with a hammer there'd be a shrine to him in TES V...