When you arrive at the gate, talk to the guard behind it. Tell him you're Friend (of course) and he'll begrudgingly let you in. He doesn't trust you so sends some Pikemen to escort you to Lord Marsten. Run at full speed to escape them and you're free to explore (and loot!) the town (the game seemingly removes them from memory once they are offscreen). Explore all you want; when you're ready to continue the story just follow the western mountain until you come to a big building built into it: this is the Crematorium the guard was talking about.
The Crematorium
Go through the curtain at the bottom and you'll find Lord Marsten just below you. Talk to him about all the subjects he offers, especially the Knights' Test, for which he gives you a password enabling you to take it. Also be sure to talk to the other two, Brendann and Caladin. They'll mention an "enchanter" fitting Iolo's description, but refuse to free him until you've proven yourself by becoming a knight.
Dupre now arrives with more suspicious Pikemen in tow and rejoins you. Now head north-east to the prison (139S 14E) and talk to Iolo. To free him you can either go through the Knights' Test or else bribe to get the key. However in order to advance the plot you must become a knight.
Knights Test
Head north out of Monitor and take north-western roads until you reach a doorway into the mountains at 112S 10W. Talk to Shmed inside the house and give him the password. He'll bring you in (alone) and give you only Leather Armour and a Mace. Head up and then dash to the right to avoid the explosions. When a room opens below you head into it. Kill the gremlins and smash the chest for a key. Head back up and to the right and unlock the door. Keys in the test are only used once, so discard it when you're done with it; the fewer keys you have to sort through in the course of your quest the better.
Head to the right and then up through the double doors. In this room you need to build a staircase out of rocks to reach the key. Snakes will be under some of the stones and will eventually respawn, so use the inventory pausing trick to build the staircase as quickly as possible. Now go and open the southern door and get the key. More traps and a Cyclops bar your way, but you can dash in and out of his reach if you're quick.
Head back up and open the right-hand door. Grab the bag (the Heal and Cure potions will come in handy!) then head downwards, to the right, and finally up. The four chests to the right contain nothing so ignore them and walk through the right-hand wall for yet another key.
Head up and to the left, unlock the door, and continue on your way. Get the key, hit the switch, and now go left and get yet another key. Head back and unlock the other door. Head onwards through the corridors and grab the claw you see there, then head back to the previous door. Now head downwards. Kill the pikeman (he can only be hit when he's visible) and read the scroll he's carrying.
Now look at the western wall and double-click until you find an opening section. Taking this route is easier. Go through and open the second piece of wall directly below you. Now head to the left and go up.
Did you read the scroll? Use the claw on yourself, then use the bloodied claw on the ashes. A wolf will spawn. Kill it grab the key out of its belly, then pocket the body (you need it for later). Note that you can repeat this process as many times as you wish for easy EXP building without hunting for targets, so carry the claw and ashes with you if you wish.
Use this final key and you'll come to Shmed. He says you should have been dead by now, so decides to finish the job himself (famous last words). Take his stuff if you want, and head back to his little house.
The Cloak
Take the wolf corpse to Cellia the furrier (139S 1W) and she'll make a cloak for you. This will take a full 24 hours, so go take a nap or solve The Silver Seed or something while you wait. The story can't progress until you've got this.
The Meat
Take the wolf meat to Lucilla at the pub (152S 13E) and she'll use it for the main dish.
Clan Tattoo
Head to Lydia's tattoo shop (147S 13E) and get a wolf tattoo. This will show up on your character portrait's left cheek from this point forwards; with this mark Monitorians will speak to you with more respect.
The Banquet
Once you've got all of this done and have picked up your cloak head a block below the inn to find the previously locked banqueting hall (157S 12E). Double-click on the doors to be taken inside.
During the banquet Flicken asks what the hardest part of the test was. It doesn't matter what you choose to say, one thing will lead to another. Harnna bursts in and announces that her daughter is missing. Luther accuses Krayg of being a traitor, Krayg draws his weapon, and the banquet dissolves into chaos.
Talk to Marsten and request Iolo be freed. He'll give his permission of course so go fetch him. The other option is to bribe Spektor for the key.
At some point after getting your Clan tattoo you will become poisoned with a strange toxin; it comes and goes, and it cannot kill you unlike normal poisons.
Go to the fields and talk to Harnna about Cantra and Healing. She'll give a temporary cure. She says she needs Varo Leaves for a proper cure and sends you to Fawn to fetch them. Look in her crystal ball to see Batlin chasing her and saying something about a Bane in her. This will become very important later on.
Simon's Ale
Talk to Simon the innkeeper and try his ale; he loves the stuff, but it causes any of your party to throw up. Now talk to Krayg; he mentions someone sneaking around near a Goblin meeting site (83S 18W). Go there and you'll find a blackrock monolith. You'll also find a bottle of Simon's beloved Fawnish Ale. Talk to Lydia in the pub about it if you wish, but she merely identifies it as his.
Anyway go accuse him; he reveals himself as a goblin and attacks you. His body has a key to the Goblin Passages; unless you're going to do that part of the game fairly soon it's probably a good idea to leave the key in his body until you need it. If you want to do it now, head straight on to the Goblin Passages.
Reclaimed Items
Iolo's Crossbow
While in the Crypts you'll no doubt come across a Crossbow. After you've become a Knight, ask Harnna about "strange Objects" and "urn", then go to Caladin with the Urn in Possesion and talk with him about "missing Urn" and you will give him the urn back and you will receive about 200 Monetari for it.
Dupre's Shield
You must be a knight in order to retrieve the shield. First of all talk to Harnna about the Plain Shield, then to Lucilla. She mentions Luther's new shield. Talk to him about it and identify it as yours (well, Dupre's) and use all the offensive keywords offered. Eventually he'll challenge you to a duel. He offers you a choice of weapons (and comments on your choice of each). You'll need to beat him in order to get the shield back. Note that if you still have a Shield of Monitor on you when you defeat him Dupre will return it to him.
Now that you're done with Monitor you can go almost anywhere else on the island. If you want to finish off the story thread of the goblin traitor you'll want to head to the Goblin Passages next; however it is by far the hardest of the immediate destinations, so you might want to do a few other places first, at least until you've got some items and raised a few levels. The next most logical destination is to go to Fawn and get the Varo Leaves to cure you. You'll also pass the Inn of the Sleeping Bull on the way there.