The potential for evil exists with Free Will.
What I think is that God knows a mans heart. He knows how he will react to any situation with his heart, but he also knows that his heart can be changed. There are an infinite number of ways a situation can turn out, and God knows all of these, and he knows which is more likely with each person, but there is still the possibility of that persons heart undergoing a change, and him following a different path.
Thats how I think about free will and all that jazz.
And God did not CREATE evil, God knew of the POTENTIAL for evil, but evil is more of an abstract notion than a solid idea. It cannot be created, and it will always be there so long as there is free will. More of a by-product that can come about by no other means.