The Dwarfs were once a proud race full of stubborn little people with hairy beards. The only contact they had with the other races were the Humans. They only traded with the humans, and felt that the Dwarfs were superior in every way possible. They were battle hardened warriors who lived for bloodshed and honor.
There days of feeling superior were limited once the Gnomes started to populate their towns. The Gnomes were given birth by Dwarfs, they were looked upon as lower class citizens for not appearing tough and brutish. The Gnomes tended to band together and used their intelligence to battle, not their muscles.
This angered the Dwarfs who started to close down Gnomish schools and attack the Gnomes. The Gnomes countered these threats with the magic that only they possessed and not the Dwarfs. The battle came to a quick end when the Gnomes stormed the Dwarven capitol and defeated the Dwarf king in combat, but made the mistake of letting him live.
The Dwarfs held a grudge against the Gnomes, but letted them do as they pleased. Until Moradin Bronzebeard created an alliance with the savage Orcs and pushed the Gnomes out of the Dwarven cities and almost from existance.