Thorin announces that the time has come for Bilbo to earn his reward. Alone, Bilbo enters the tunnel that leads to the dragon’s lair far beneath the Lonely Mountain. At the tunnel’s end, Bilbo sees Smaug for the first time, lying atop his huge heap of treasure. The beast is sleeping. Bilbo steals a cup and returns to the dwarves, who are excited by his accomplishment. When Smaug awakes, however, he misses that cup, and he shakes the roots of the Mountain in his fiery rage. Smaug flies forth from the Mountain, breathing fire on it and the surrounding area. The dwarves and Bilbo take shelter within the entrance to the tunnel until Smaug returns to his lair. Thorin and the others even blame Bilbo for disturbing the dragon. The hobbit, however, defends his actions, pointing out that he could not steal all of the treasure all at once, and that the dwarves have made no plans of their own for dispatching Smaug. The dwarves apologize. Bilbo has "become the real leader in their adventure."

Bilbo returns to Smaug’s lair, with a plan of his own. He puts on the Ring and engages Smaug in a conversation full of riddles. Smaug smells but cannot see his visitor. Despite this fact, he is vain enough to be willing to show off his jewel-encrusted underbelly to Bilbo. The hobbit spies a bare patch where the dragon would be vulnerable. He leaves, but not before making one last teasing comment, which again infuriates Smaug. Back on the "doorstep," Bilbo tells the dwarves what he has learned. He throws a rock at the thrush, who appears to be listening, but Thorin tells him that the thrush is from an ancient and magic race of birds which Men used to use for carrying messages. Then the dwarves fall to dreaming about what they will do once they have recovered their treasure. Thorin is especially interested in finding the Arkenstone, the fairest and largest gem of all delved by the dwarves. Eventually, Smaug again emerges, angered and eager to remind the world "who is the real King under the Mountain!"