Given that this is clearly an OTB situation, it would depend on how a TD would penalize the illegal move during competitive play. For club / casual play, it's considered classy to politely inform him that he did it, if you noticed it.
The way I would run it (and as a TD, I have done so in the past)
1. Player A sees illegal move by Player B.
2. Player A stops the clock (something he can do if he has a TD claim) and raises his hand.
3. TD approaches board and asks A and B what happened.
4. If there's an agreement to the illegal move, the TD can dock a clock penalty (subtracting B's clock by penalty amount) to B.
5. After penalty is applied, clocks are started and B gets to repeat his move.
Now it is very likely that you may miss the opportunity to report it. Well, if you moved without reporting it, you may still report it after your opponent's next move if the board looks unnatural (two kings in check simultaneously etc.). Sometimes, if the illegal move is irrelevant and you have a forced win, you probably don't gain much from reporting it anyhow. :)
I've never run into this problem, but a friend of mine has, and I was curious, because in an endgame with time pressure, this could occur. I was wondering what would/should happen if my opponent were to make an illegal move which is also a mistake. Assuming I notice the illegal move, am I obligated/expected to inform my opponent, or am I allowed to refute the mistake without claiming the illegal move?