I'm assuming you've already made your decision but I thought I'd chime in here.
Remember, that not all line employees make good supervisors. If you hire the inside guy, be prepared to mentor him (very rewarding, I might add) and groom him to be a good supervisor. The responsibilities are very different.
We see it all the time in sales. If a sales guy has a huge impact as a salesman, management has a tendency to wan to promote the guy to management. The theory is, of course, that his skills and abilities will somehow transfer to other sales people and the company will therefore make a mint.
'Tain't necessarily so. If he has no leadership abilities needed to be a supervisor or manager, he's simply going to fail at the new job.
With your inside guy, you have to assess as accurately as possible whether or not he has those leadership insights and talents which can be leverage immediately for the position. Has he shown demonstrable ability in the past to rally his co-workers to a cause that furthers the efficiency of the company? Does he set an example for his co-workers already? Demonstrate generosity and the nature of a servant? Care about the company but also the other employees? Exercise discretion and tact? Those can all help; of course, there are many others.
All of which can be trained into him if the company is willing to make the investment in him.
If there is the remotest chance that he can succeed at the new position, put him (your current employee) in it but be prepared to work on him. He's probably a diamond in the rough but he won't just magically turn into a supervisor. You'll have to work on him. I agree with you wholeheartedly that hiring the inside guy is tons and tons better than going outside the company. I highly recommend it, not because it's a reward, as you say, but because he knows your company's culture and has already demonstrated a tenacity for staying in the company.
When you offer him the position, however, I would definitely lay it all out for him. You think he's a wonderful employee (or however you say it in your company!) and that you expect good things from him. But outline a plan to give him the skills he needs to succeed at it. Or hone his existing skills. Make him commit to that plan and include in that plan leadership training outside the company, regular (monthly? quarterly?) progress interviews with you or his boss.
I'll just say one more thing. Even though I recommend hiring the inside guy if there is the remotest chance he will succeed, rest assured, his chances of succeeding are going to be greatly enhanced IF the company will throw it's weight behind supporting him in becoming the supervisor he can be. If the company puts him in that position and he fails because there is no support, then the company is at fault and reprehensible for doing so.
Tell us what decision you made. I'd love to hear about it.
--Wag--