Microcephaly, a genetic disorder that has been well-studied in zebrafish and other vertebrate species. The mutation can be either dominant, recessive, or sex-linked. As your parental stock look normal, what you are dealing with here is likely a recessive mutation that is being passed through the germline. This means that both parents necessarily carry one copy of the mutant allele, that is, they are +/m heterozygotes. In your case, we know that your male definitely carries the mutation (+/m), and if he mates with a female (probably his sibling) who is also carrying the mutation (+/m), then Mendelian inheritance predicts that 25% of their progeny will be m/m and show the deformity, 50% will be +/m 'carriers,' just like their parents, and will appear to be normal, and 25% will be truly normal, wild-type individuals (+/+) both phenotypically and genotypically, However, if your carrier male (+/m) mates with a female that does not carry the mutation (+/+), then all of their fry will appear normal, but 50% of them will carry the harmful recessive mutation (+/m), just like their father. In this case, the deformity would then reappear in the next generation.
I know this is bad news. I applaud your decision to tackle the problem head-on, rather than ignoring it and passing it on to other hobbyists; more people should be so conscientious. I would suggest the following- (1) Do not distribute any of these fry to other hobbyists, even if they appear to be normal, because many of them are still carrying the deleterious mutation. If you want to keep some of the unaffected 'carriers' for you own pleasure, that's fine, but do not breed or distribute them. (2) Cull all the affected individuals. Clove oil is an effective and humane form of euthanasia. (3) If you are interested in propagating this species, start with new breeding stock, preferably from a different source (or two). Yes, it would be theoretically possible to identify wild-type individuals (+/+) among your existing progeny, but this would be a long, drawn out process that would require at least two more generations. For a fish teetering on extinction in the wild, sure, but more trouble than it is worth for most fishes.
Sorry for the bad news, but as always, there is a silver lining. First, you should feel good about doing something really positive for the hobby; and second, you can rest assured that you are not doing anything 'wrong' with any aspect of you fish-keeping, such as water chemistry. Your fishes have been dealt a bad hand genetically; it's what happens when breeders ignore the consequences of inbreeding.
Good luck.