Well if i have this right, you are just hearing rumors that this person likes you from third parties. If they want to date you, they should go up to you themselves and talk to you about their feelings, not pass it along through your friends, this isn't middle school.
So, you really have no obligation to do anything. Which way of action is more "cruel"? Honestly it doesn't really matter, because either action could be argued as "more cruel". Do whatever you feel comfortable with. If you get bad vibes/ the creeps from this person then go ahead and avoid them. If you feel they are worth keeping around as a friend then do so, and if the feelings issue comes up, just be polite and firm that you are not interested in anything romantic. Obviously, don't mock-flirt with them/tease them/be overtly cruel, but I don't think you were going to do that anyway. If they get all emo and butthurt about a civil rejection, that's their problem. It's not your fault or responsibility.
If the person is mature, they should be able to take the rejection and remain friends with you, OR if the feelings are too intense, they should take the initiative to distance themselves from you until they get over it.