What date did the council write to you, and did they give you a time limit to reply?
Obviously, the longer you can leave it the better. If you do get another letter stating that the payments are going to be redirected to the tenant, call and say that you are appealing the decision, and follow it up in writing.
Why are you getting direct payment?
Was the tenant getting direct payment, and then got in arrears, or have the arrears come about because they have failed to make top up payments?
Does the tenant pay the rent in arrears, or did they make a rent payment in advance on move in?
You do not do anything about the deposit until the tenant has left. For all you know, the tenant may be there for another year. You have not applied for possession, and the tenant has time left on their fixed term of the tenancy, so they cannot give a notice to quit.
Stalkers, please go over this comment with a fine tooth comb.