Hmm, that sounds like rather sloppy policework. If the authorities saw the evidence and neglected to confiscate the computer... indeed, handed the computer back to the suspect, thus allowing the suspect to "hide" or tamper with that evidence... then they are stuck with having made a pretty danged lousy decision. I don't know about Canadian law, but in the USA I think that the testimony of a police officer having witnessed evidence of a crime is sufficient probable cause to have a judge issue a warrant. The warrant would require the suspect to turn over the files. Now if the suspect refused to, he can be jailed for contempt... but cannot be charged with the crime itself. 'Tis a conundrum, but the bright side is that a guy with child porn will sit in jail one way or the other.
As I understand the issue, it isn't that there isn't evidence to warrant them searching his computer right now, it's that the guy can't be made to incriminate himself by giving up the password. They can't get a warrant to make him give up a password. They can get a warrant to search a computer, but there is no way for themt o get the password to actually search the computer.