libtelnet | Simple RFC-complient TELNET implementation as a C library | Telnet library

It's not readline that should be changing its behaviour IMO, but libtelnet that should be performing the appropriate translation.

The documentation for libtelnet mentions

• void telnet_send_text(telnet_t *telnet, const char *buffer, size_t size);

Sends text characters with translation of C newlines (\n) into CR LF and C carriage returns (\r) into CR NUL, as required by RFC854, unless transmission in BINARY mode has been negotiated.

so it should be able to handle this. You'll have to show how readline is talking to libtelnet if you need more detailed help.

Edit - it looks like you're using libtelnet to handle input from the telnet client, but allowing readline to put characters directly on the socket back to the client. This is a mistake. Per the libtelnet documentation:

Note: it is very important that ALL data sent to the remote end of the connection be passed through libtelnet. All user input or process output that you wish to send over the wire should be given to one of the following functions. Do NOT send or buffer unprocessed output data directly!

That is, you need