I did and they have another hostage ready to chop his head off.
The way to deal with these people is to ignore whether they have the second hostage (assume he's already dead, even if that's technically premature) and to bomb the area, preferably with something like white phosphorous incendiaries. It also needs to be done soon, because people regard such actions less favourably when it is longer from the event which the punishment is being meted out for. Make it very clear that once someone starts killing hostages, reprisals will come. If you don't, the next damn terrorist group will think they can get away with this sort of thing too; you're not protecting those already captured, you're protecting everyone else.
It's a shame, but being this nasty is the only way of hammering home to idiots that fucking with is a seriously bad idea (unless you can act with more precision and kill just the terrorists). And it does work: it's been proved to work over and over throughout history. It probably needs to be accompanied with a full apology to any innocents caught up in the crossfire to mitigate incidental downstream trouble.