How you proceed from here depends on how you arrived: from Warakiya Village or from the Clock Tower.
You start here if you came from Wallachia Village.
Collect the Hearts, but beware of the spiked mashers along the way. While contact from below or the side is deadly, you can stand on top of them safely. Deal with the chasing Ghost and ascend the stairs.
Dispatch the bone-throwing Skeleton, then watch out for the Whip Skeleton. His reach is as long as yours. Climb up the stairs and you will climb on up until you emerge in Block 3-01.
You start here if you came from the Clock Tower.
Collect hearts and watch for blinking eyes. These indicate the presence of Owls that will swoop down on you. The Boomerang you collect along the way can be handy against them. Also watch out for the water pits, since you can't swim. Cross all the way to the door leading to Block 3-02.
This will be your first exposure to Red Skeletons. You can knock them down but they'll keep coming back for more, so just run past them while they're down. Also watch out for the Hunchbacks. Climb up the stairs.
The first thing you'll run into next is that infernal twin-headed fireball-spitter. Time your ascent to avoid getting singed, then lay on it with your whip. Deal with two of these as well as the odd Hunchback and climb on back down.
You're back on the level where you started, only across the wide gap. Step into door...where you will have a decision to make.
Watch out for the Raven as you emerge. Collect the hearts, then climb down the stairs.
This next area is full of floating jellyfish. Try to avoid attacking them since they have a tendency to explode into dangerous spores when you do. The ones on the ground can usually be handled safely through constant whipping to beat down the spores. Climb down the stairs when you reach them (but be careful of jellyfish on the way down).
Be careful of the Whip Skeleton in the next area. Collect from the candles and proceed to Section 04.
Another Whip Skeleton awaits you, but worse are the Spiders. They'll drop down on lines, and if you don't (or can't) hit them before they hit bottom, they'll send a spider kid your way on a course littered with gaps. Try to make your way across quickly to minimize the danger. After another Whip Skeleton, climb up while avoiding the Spiders. Then climb back down to where you can reach the candles and continue on down.
From here, it's a short trip right to the stage boss: the Cyclops. Once you defeat him and take the Crystal, a statue in the background will crack open, revealing it to be a petrified human restored: the sorceress Sypha Belmades. At this point, you can choose to recruit her. If you didn't get Grant, there is no downside to recruiting her. If you have Grant, however, the choice is up to you. Both have their benefits and drawbacks, and recruiting Sypha dismissed Grant.
Regardless of your choice, the stage will be cleared, and you will continue onward to the Haunted Ship of Fools.