But God shows his love for us in that while we were still sinners, Christ died for us.
In your world, I have another name. You must learn to know me by it. That was the very reason why you were brought to Narnia, that by knowing me here for a little, you may know me better there.
I couldn't find anything definitive in the rules or FAQ. The rules for The Wizard's Tower say on page 13 that "The Dragon does not breathe fire if it is stopped from moving by a card" (emphasis mine). Since it specifically calls that out, but not when he can't move back, I'd let him breathe. The chart for movement also lists an entry of "No movement. Breathe fire." on a 3.
Perhaps it could have been clearer, but the fact that the above line was added to the rules seems to indicate that that is the only thing that would prevent the dragon from breathing fire aside from being in the castle ring.
We've had the dragon turn up in only one game so far, and it appeared in an arc which had no wall nor tower, and the opposite wall and tower were gone as well. It's movement went forward and backward breathing fire without effect through the two empty arcs for 3 or 4 turns. We then drew a colored fireball to hit it with and focused our attention on more pressing monsters. In the end, we only spent one hit card on it. It hardly felt like a threat at all, aside from being a monster on the board that we needed to eliminate to win.
The movement/action chart for the dragon indicates two outcomes--first movement, then breathe fire. It makes sense that both should be resolved if possible. Otherwise, it would make for a pretty lame "megaboss".