This might be simplifying it, but:
You can't really combine the Physics Behaviour with other movement behaviours. This is because the physics behaviour is expecting to see the object physically move around (because you applied force to it, or something ran into it, or whatever.) If you don't move it using force, then it's acting really weirdly from the viewpoint of the physics model - kind of warping around the place without actually moving - and you'll get really weird results.
So just apply force to the character to make him move around, and remove the 8 direction behaviour completely. Here:
http://files.getdropbox.com/u/906550/Co ... hysics.cap