Certainly report it, you never want to hide things in case anything ever comes out in the wash. However, you have a solid explanation and often times schools will see the Graduate GPA, and see your dedication to improve. In the long run there are going to be candidates that go through undergrad and get a 3.6, and if their GPA falls in graduate school often times its shrugged off because individuals can show a decrease with slightly harder material. In your case you showed improvement, you went against the norm. I think that with the write explanation you can turn that experience into a strength, and certainly make your application stand out among others.
“Focus on the journey, not the destination. Joy is found not in finishing an activity but in doing it.” - Greg Anderson
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