Thanks. I never intentionally changed the system locale but it is fixed now. 
For those who are interested, this is how you do it. Change in
  /etc/default/locale
the line
  LANG="en_US.iso88591"
to
  LANG="en_US.utf8"
and all new shells will automatically use this locale

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https://bugs.launchpad.net/bugs/1089302

Title:
  psql client by default in LATIN1 while should be UTF8

Status in “postgresql-common” package in Ubuntu:
  Invalid

Bug description:
  psql from postgresql-client-common 129ubuntu1 is by default in LATIN1
  encoding while it should be in UTF8. This results in problems such as:

  dbname=# select * from tname;
  ERROR:  character 0xc487 of encoding "UTF8" has no equivalent in "LATIN1"
  dbname=# set client_encoding to 'UTF8';
  SET
  dbname=# select * from tname;
  ...

  All databases in postgresql are created by default in UTF8 (or UTF-8
  whatever is more appropriate) so the client should also have the same
  default setting.

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