Enter the Ulkan Mines. Go into Watts' Workshop and talk to him about his lost hammer. Go back to the entrance of the Mines and talk to the pole to have the Dudbear Express take you to Digger's Hideout. Pick up the Hammer that is laying on the ground and leave the room.
Look at the map to see how to get back to Watts. When you return the hammer to Watts and you are finished with this event.
Upon Completion: Return home, talk to Lil' Cactus, go downstairs (watch him write the Event on the leaf), and go back upstairs to save your game before continuing.