Before you can continue, you must talk to the water mill keeper to make the elevator work.
Visit the People you Rescued
If you talk to the old woman in the northwest house, agree to be treated like one of her children. Her husband is the village Chief, but he is still missing. You can go upstairs to his room and check on the rocking chair to see some text.
Talk to the tool shop owner and she will tell you that she will give you a new free Medical Herb if you use yours. This will be very helpful, so don't forget about it.
Next, talk to the bridge guard, who will let you pass.
Fix the Water Mill
East of the bridge is the water mill keeper's house. Talk to him, and, after walking in front of the wheel, agree to try to turn the wheel. It will turn and the water mill keeper will realize that he was trying to turn it the wrong way.
Get Some Items
Before you go back to the Underground Castle, go south from the water mill keeper's house and walk down the ivy that is just beyond the narrow gap in the stones. In this room, you will find Iron Armor, 50 GEMs, and a Crystal Fairy who will give you EXP.
Be sure to equip the Iron Armor, then return to the Underground Castle.