It does look like there is a blue layer underneath. Any damage on the other side, where the flat metal strip runs down the length of the battery from the positive?
The covering on the metal strip Can Not be starting to tear at all. The inside of flashlights carry the negative connection, the metal strip just has to short against the side and you could get the “vent with flame”.
Personally I would rewrap it anyway. Its cheap & super green.
That particular battery could be made a tiny bit slimmer… but maybe I shouldn’t suggest it, slightly risky if one is not careful. 
You might want to try some Efest IMR 10440 350 mah Li-ion Safety & Shopping Guide (scroll down a bit). IMR doesn’t have protection (less needed) so without the connection running down the side for the protection circuit… they could be slimmer.