I needed to add the command line parameters or KDiff3 would only open without files and prompt me for base, local and remote. I used the version supplied with TortoiseHg.
Additionally, I needed to resort to the good old DOS 8.3 file names.
[merge]
tool = kdiff3
[mergetool "kdiff3"]
cmd = /c/Progra~1/TortoiseHg/lib/kdiff3.exe $BASE $LOCAL $REMOTE -o $MERGED
However, it works correctly now.