Number one is absolutely correct. A contraction (i.e., "it's") is frequently used in this setup, but that would be inappropriate in formal writing.
As for number two, it may be correct, although there is the possibility that it could be interpreted as ambiguous: "It is that they were too afraid to fight more" is sufficient to form an independent clause (meaning that they no longer wanted to fight, because they were scared). However, the "than" that follows just throws the reader off and detracts from the clarity.
While both may be right, number one is clearly right, and I therefore recommend that you stick with that sentence structure.
Best of luck!