There are three outcomes to the theft, and the correct one is the hardest to get. The key is to figure out why Garidin has flowers in his house, so try see if anyone in the town knows about flowers.
Viewing post in The Thackleton Traveler comments
For the waterfall puzzle: To reach the stone piece you need to first switch on the red lever, the green lever and the blue lever. Then you can reach the yellow lever on the top row. Switch on the yellow lever and then go back down and switch the green lever off again. Then go up to the top and ride the waterfall to the left of the yellow lever down to the lower level, and you can reach the stone piece.
To reach the key, you need to get the purple lever (metal shaft) from the prison first, then you can get to the broken lever base by switching on the blue lever. Use the metal shaft on the lever base to complete the purple lever, and then switch on the purple lever. Finally, make sure the blue lever is switched off and the red lever is switched on. Then you can ride the waterfall in the middle of the room down to reach the key.
For the theft, you need to talk to everyone in the town about the event the night of the theft (you don't need to talk to the mayor, the innkeeper or the blacksmith). Once you have talked to everyone, talk to Dalton again and tell him you have a suspect and it's Garidin. When he asks why, tell him he wasn't seen. After this you can ask Dalton to search Garidin's house.