I too think you should ask him what he'd like to be called. My husbands step father was soooo offended when I was pregnant with dd and sent dh's mother an e-mail asking about her side of the family for some geneology history to put in the baby book. My husband calls him, Tom, not Dad. DH's Dad walked out when there were FIVE young boys in the house (aged about 5 to 12). In came Tom, and raised these kids. So when I neglected to consider him as the granddad he was rather offeneded. It just didn't occur to me. But, we of course now refer to him as "Granddad". There is no issue of competition because my husband's father passed away before I ever met him, and before dd was born.
In retrospect, I think Tom Tom deserves HUGE credits for raising another man's 5 children. I think it's a lot of work to raise your own kids, but it takes someone really speacial to raise someone else's kids... FIVE of them.
Anyway, I felt like such an ass for offending him. OOPS!
However, when dd is old enough, I will explain to her ther her paternal grandfather is dead. I will tell her who he was and what happened to him. But, we will always refer to Tom as "grandad".
Ooo... that turned into a long post, sorry.