Terminal.app and the European Unicode characters?

Does anyone have the unicode characters working properly in Terminal.app?
If I try to write in GNU nano 1.2.4 for instance "örrör" it translates into:
(one empty line)
örr
ör
which isn't certainly right. This is especially awkward when editing an unicode text file where the text then easily becomes more or less garbled. Usually more.
It doesn't seem to make any difference whether or not I use the Finnish extended (unicode) keyboard layout or the conventional one in nano. If the Terminal.app window preferences are set as UTF-8, it says:
?rr
?r
which looks even more garbled.
In plain bash the characters print like this:
å = \345
ä = \344
ö = \366
so my mighty apple translates the example string "örrör" as "\366rr\366r".
Any ideas, anyone?
PowerBook G4 @ 1.5 GHz   Mac OS X (10.4.4)   1.25 GB DDR SDRAM
Debian Sarge 3.1 as a slave fetchmail server.

Hi solarflare,
   My first (and essentially only) language is English as well. However enough folks have asked that I have experimented with multibyte characters. There are so many apps and options involved, it's difficult to get consistent results. However, I'll recount as many settings as I can recall.
   To begin with, you are right about the LC settings. It helps many apps to have:
export LCALL=enUS.UTF-8
export LANG=en_US.UTF-8
set in your shell startup scripts. Then the system should be set to produce unicode when you type. In the "Input Menu" tab of the "International" pane of "System Preferences", you should select a unicode keyboard layout, such as U.S. Extended.
   To configure the Terminal, you need to open the "Terminal Inspector" by selecting "Window Settings..." in the "Terminal" menu. To type many multibyte characters, you need the option key. To use it, you must have the "Use option key as meta key" checkbox unchecked, although I find the meta key too important in UNIX to leave that unchecked. In the dropdown menu in the "Display" pane of the "Terminal Inspector", you should set the "Character Set Encoding" to "Unicode (UTF-8)". In the "Emulation" pane of the same window, you must uncheck the "Escape non-ASCII characters" checkbox. That is important as I've read that it is checked by default and that can produce some pretty strange results.
   Now it's helpful to use a very modern shell. For instance, the latest beta version of zsh-4.3 has the best unicode support of all versions of zsh. After you've chosen a good shell, you're at the mercy of the application that you're using. As I gather you've noticed, vim has excellent unicode support and picks up on the LC settings. I have no idea about nano but it is meant to be a minimal text editor.
   I know that my settings allow me to type extended characters and the "Character Palette" lets me insert more. As far as other command line utilities go, the best you can do is to choose well and keep your apps as up-to-date as possible. Fink or Darwin Ports can often help in that regard.
Gary
~~~~
   This generation doesn't have emotional baggage.
   We have emotional moving vans.
         -- Bruce Feirstein

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