After regaining the Airship, go back to Mobliz, in the eastern end of the thin strip of land.
Go to the southwest house in Mobliz and walk behind the bookshelf, then make your way southwest into the wall to reach another room.
Go farther into the room and watch the cutscene. Afterward, go upstairs to fight Phunbaba/Humbaba.
Phunbaba/Humbaba is weak to poison and absorbs lightning. After a while, Phunbaba/Humbaba will use BabaBreath/Humbaba Breath to kick two characters (chosen at random) out of the battle. Then Terra will appear, and she will be in Esper form this time, so her attacks and defense will be twice as strong.
After Phunbaba/Humbaba is defeated, the children will recognize Terra in her Esper form, and Terra will regain the will to fight, joining you permanently.