The first "small ones" are indeed the dwarves. The second are the goblins.

Yes, the challenge is the Balrog.

I'm not certain that Gandalf was the one to summon the bunny, though. My Dark Muse™ (as opposed to pandemonium213's Dark Muse™) has eight legs, likes to walk across my ceiling and has a rather disturbing habit of dropping uncomfortable story ideas on me... :-D