How to tell my MS advisor I've changed my mind about doing a PhD with him?
Two points: 

First, just because your new supervisor offers you a PhD position does not mean that you are in any way obliged to take it. That said, don't hide the fact that you are going to consider sending applications out to a variety of programs. The thing that will cause hard feelings is if your advisor thinks you are going to join his or her group and turns other people away, only to have you leave. If your supervisor is a professional, he or she will recognize that you pursuing other opportunities is not personal. You have to do the best you can for your career, and if that means taking a better position elsewhere, then you should do so. (Note that you can also get outside offers and use these to negotiate better pay as a PhD student, but that's a different issue, and somewhat more complicated politically.)

Second, don't under any circumstances work for a group that makes you be slow and do poor work. Academic hiring is cutthroat competitive, so if you want to actually get a job, you're going to have to produce a lot of very good work, and you're only going to do that if you're surrounded by other people who are trying to do the same who push one another.