While the dwarfs aren't completely innocent (They could've just come in peaceful with the fairies, or maybe just move elsewhere. Earth Dragon Island sounds like a more ideal place for them to move into, though then again, these aren't (mostly) your stereotypical dwarfs.), it was indeed the humans, who by driving the hydras into extinction, forced them out of the marshes. It was unfortunate what they did after, but it was the humans who drove them out.
So in a way the humans were indeed responsible.
It's a situation that can never have an ideal outcome. The most you can hope is a bittersweet conclusion, by taking the Save Kid Path and ensure that the hydra's offspring lives. Sure, you can't stop the dwarf's massacre in time to tell them there is still hope, but at least the dwarfs do understand and are reasonable when they're finally told, opting to return and protect the little hydra.