Wow! Uberthread!
Ambrus,
Thanks for posing the question, even if you didn't intend to generate this kind of response. It was a fun read. Personally, your campaign sounds like a blast, and I'm generally with the moderate opinion here (as a DM). Yes you could have handled it better, but I don't think your handling of it was either cruel or enough to end your DMing career. I will share a personal anecdote that's similar. In what my players (3 years later) are still calling the best campaign I ever ran the following situation occurred.
The city of Shantel (hometown of all 5 PCs) is being besieged by Grimosh the Lich (20th lvl cleric/wizard) and his army of undead, half-dragon/half-trolls, and various orcs, goblins, etc. He has arrived outside the city with his army and offers the city 3 days to surrender unconditionally. The PCs are 5 level at this point and Grimosh has been their major antagonit from the start. The reached the city before him, bringing news of his impending assault and so are on the city's walls to hear his offer. The NG dwarf cleric of Moradin, seething with righteous anger at the undead abomination below him defiantly fires off a searing blast, which against all odds breaks SR and causes a slight wound to the archlich. Said lich proceeds to throw a blade barrier up right behind the cleric and then pound him with fireballs until well done.
Killing that character was completely my call. I gave him no real chance to escape or survive. He did it knowing there was not a high enough level cleric in the city to raise him from the dead. I didn't feel sorry for one second. He was, of course, quite upset. My fiancee (happily now my wife) was also quite upset. We got past it. As is our custom, he was allowed to make a new character with minimum exp for the level he died at plus RP exp earned for the session where he lost his character. I gave him bonus RP exp for such a dramatic and in character response. My fiancee's bard used the character's death to rally the city to their own defense. He made a new character that he claimed later to enjoy more thoroughly.
However, he left the game upset. I nearly spent the night on the couch because my fiancee was upset. While I agree that swrushing's point of view is an excellent general rule, it is not always the case. To this day, I adamantly state I made the right call as the DM (other players agreed at the time as well). Given distance and some DMing experience of her own, by wife now agrees with me. Since he ceased playing with us about a year after that campaign ended due to work and other personal issues, I don't know if the player in question did. The moral is that his character didn't die because the player or character made a mistake. His character died because he the player and his character made a decision, and the world reacted in the most reasonable fashion.
Could I have handled it better? Perhaps. Maybe I should have left a way out for him, or provided a way for him to resurrected. In hind sight, I don't think so. A few of my players wanted me to reverse my decision, but I refused and told them to take it in stride and move on. As a result of role-playing out their character's emotions of the issue, Grimosh became fixed in their minds as a great example of what a bad guy should be. They hated him, but having gotten it out of their systems, the were no longer mad at me.
Here's hoping you can pull something similar. Give the PCs the chance to vent their anger where it belongs - on the gnomes. Let them have their satisfaction and recover their item on their own, and then carry them on to the end of the campaign. If you learn from the understandable mistake you've made and build it into what seems to be an otherwise very good grasp on DMing, chances are good that in a few years, you'll all sit down to play, and while you're breaking out the books and paper, one of your players will say, "You remember those stupid gnomes? Jerks! We really gave it to them!" (more probable commentary editted for Eric's G-ma.)
Good luck,
Z
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