Dwarves... or Gnomes?
The picture is from Karl Gjellerup's book Den Ældre Eddas Gudesange [The Divine Songs of the Elder Eddas] Kalliope, Denmark, 1895 [re-released by Thaning and Appel, Copenhagen, 1973]; some call these figures 'gnomes'. [The background of stone work is added by this author.]
The term gnome appears better attributed to Paracelsus, where they are described as 'elementals' having to do with the earth. This may have led to confusion of the terms, since dwarves are usually identified as 'soil dwelling dwarves' [the old Norse Eddas], or below-ground stone and metal smiths [Tolkien].
 
Even the term gnome is not settled in its origins; while some attribute it to the Greek gnome 'to know', others from the Greek genomon 'one who knows', and by extension 'guardian' (of treasure), yet others say Greek genomus 'earth dweller' [presumably from ge, gaia 'earth' + nómos 'an allotted abode'].

Mythologically Dwarves are believed to live in subterranean halls, or mines, and guard great treasures. The term Dwarf traces back to ancient Northern European roots [e.g.: Swedish dverg, Old German twerg], but its origin is essentially unknown.

 
 
                    To the right is the contemporary view of a gnome [by Rien
                    Poortvliet and Wil Huygen]. While it has some things in common
                    with Tolkien's Dwarves, the concept is actually much
                    different. These beings were considered rather tiny, often
                    less than a foot in height. They are less frequently associated
                    with the earth and stone, and often associated with wild
                    animals and even farmsteads. By some accounts they are
                    considered 'deformed' dwarves.
 
 

Brian Froud and Alan Lee have depicted Dwarves
more in the vein of Tolkien, larger in
stature and more human-like, although
still bearded and aged. Dwarves are
usually described as less friendly to
human-kind than gnomes, but always
as craftsmen and smiths.
In the Norse Elder Eddas the Dwarves
also fashion a beautiful necklace [in
The Silmarillion the Nauglamír] and
a magical ring that forever creates wealth
for its possessor.

In his early writings Tolkien used the term Gnomes to describe a division of the Elves, but by the time of the publication of The Lord of the Rings he had changed the name to Noldor. The latter term derives from an Elvish stem ÑGOL- 'wise' ... ÑGOLOD- 'one of the wise folk' or 'Gnome', which in the High Elven tongue was 'Noldo', plural 'Noldor'. This leaves little doubt from whence Tolkien thought the term 'gnome' derived.

It is certainly generally true of early European mythologies that usage of the terms gnome, dwarf and elf were often interchanged or overlapped one another.