SFTP is an officially supported protocol for Connect-FTP in Pega 7.1.9 and later. Pega 7.1.8 only supports the non-compatible "FTP" and "FTPS" protocols. If you would like the out-of-the-box SFTP support, you should upgrade to the newest Pega release.
The response you are getting is expected. The server is saying "I am an SSH server" when you are trying to open a connection to it. SFTP is an extension to SSH.
I do not understand why you would do tools.getParamValue here. That gets a value off of the current Parameter Page, using some key that is already on the Map.
If you just want to set the path, use forward slashes ('/') or escape your backslashes ("\\").
String localFile = "D:/Temp/MyFile.txt"
String localFile = "D:\\Temp\\MyFile.txt"
Update: after reviewing your document I see that you have used "getParamValue" when defining every String variable. This is incorrect, and you will get null/empty values for every one of those Strings.
I have placed the jsch-0.1.54.jar (downloaded from sourceforge) in to the lib path (D:\Apache\Tomcat\7.0.57\lib) of our tomcat server followed by a restart.In addition, I have added a DSS compiler/defaultPaths as well.
Not sure what else to be taken care to import the above mentioned library properly.