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'The Hobbit:' Inside Peter Jackson and Warner Bros.' $1 Billion Gamble

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The digital camera's unforgiving eye also required production designer Dan Hennah to create hundreds of props that look authentic. "We had bookbinders, musical-instrument makers," says Hennah. "Pretty much every craftsman you can imagine in Middle Earth was here." His workshop is a treasure trove of beautifully fashioned items, from Gollum's macabre boat, made of an orc's skeleton and goblin skin, to a finely engraved dwarf's ax stuck in a stump, to slender yellow glass elf goblets. This is the room that obsessed Tolkien fanatic Stephen Colbert when he visited the set last year. (It turns out that Colbert can read Elvish.)

STORY: Third 'Hobbit' Film Sets Release Date

One thing that became easier: hobbit feet. In the Lord of the Rings films, the hobbits wore foam latex feet that had to be glued on laboriously, and maintaining the look was a constant challenge. "We were down on our hands and knees a lot," says prosthetics supervisor Tami Lane. This time, Richard Taylor devised silicon slip-ons, which go on in about 10 minutes. "And they can actually waggle their toes and feet, so it's much more believable," says King. But once again -- the hair. There are people in the crew whose only job was to apply hair to hobbit feet. On Hobbit, nothing was really easy.

The tangled web of the Hobbit movie begins in 1969, when Tolkien sold film rights to the book, as well as the Lord of the Rings trilogy -- The Fellowship of the Ring, The Two Towers and The Return of the King -- to United Artists. A few years later, the studio made a deal with Saul Zaentz to produce the movies -- an arrangement that yielded Ralph Bakshi's animated Lord of the Rings in 1978 (and that, in turn, inspired the then-teenage Jackson's interest in Tolkien). An accounting dispute of many years' duration followed, and under a settlement, Zaentz wound up with the rights to Lord of the Rings. But United Artists still was locked in as distributor of Hobbit.

In 1994, Harvey Weinstein's Miramax acquired Jackson's breakthrough film, Heavenly Creatures. Weinstein wanted to do more with Jackson, and Jackson wanted to tackle Tolkien. The plan was for Jackson to make a Hobbit movie and, in success, follow with two Lord of the Rings films. Given that Weinstein was, at the time, bailing Zaentz out of a financial crisis with The English Patient, it seemed that a deal could be made. But Weinstein found that United Artists was part of the Hobbit equation -- a sticky part -- so he proposed jumping straight to Lord of the Rings.

The idea was to make two films at a combined cost of $120 million. But Michael Eisner, then-CEO of Disney (which owned Miramax), balked and wanted to finance only one. Now it was Jackson's turn to balk. Having already spent about $10 million to develop the project, Harvey and Bob Weinstein allowed Jackson just three weeks to find another buyer. Any deal had to give the Weinsteins and Zaentz executive producing credits, reimbursement for their costs and a piece of the gross profits.

Jackson and his team found their way to New Line Cinema -- at that point, their last resort. After looking at Jackson's models and a reel of material, chairman Bob Shaye asked the magic question: If there were three Lord of the Rings books, why not do three films? It was a huge gamble considering that Jackson was a cult filmmaker with a total box-office haul of $30 million.

STORY: No One Knows How Much Peter Jackson's New 'Hobbit' Film Will Cost

New Line rolled the dice and greenlighted the trilogy at about $210 million. The final price tag was more than $300 million, partly because of the complexity of the material and partly because, after the first film in the series, The Fellowship of the Ring, was a massive hit, New Line was willing to spend more money. But as the movies started to generate huge returns, Jackson's relationship with New Line began to sour. "When you make films that gross hundreds of millions of dollars and are critically lauded, it's natural to expect more creative freedom and resources," says an executive with ties to the project. "When those expectations don't track with the studio's processes, tension is inevitable."

In August 2005, Jackson -- who also had a piece of the box-office gross -- sued New Line, demanding a thorough audit. "I've never been involved in a lawsuit in my life before," he says. (Zaentz already had sued New Line over profits in 2004, and the Tolkien estate would sue in 2008. All these cases settled.) Jackson said he wouldn't make another film with New Line until the situation was resolved. In a January 2007 interview, Shaye said New Line had paid Jackson a quarter-billion dollars before the suit was filed and vowed never to work with the director again.

Shaye wanted to make Hobbit with Sam Raimi (Spider-Man) directing. But UA -- by now part of MGM -- still had its rights, and that gave MGM chairman Harry Sloan veto power. "Harry said to New Line, 'Fix your Peter Jackson problem,' " says Kamins. Meanwhile, pressure on New Line was building, as the studio's rights to Hobbit would revert to Zaentz if no progress was made.

So a few months after his angry outburst, Shaye began to sound conciliatory. And in December 2007, as New Line faced a humbling failure with the costly Golden Compass, it was announced that Jackson, along with Walsh and Boyens, would executive produce and write two Hobbit movies, in partnership with New Line and MGM, to be released in 2011 and 2012. Jackson still had hard feelings about the litigation, but by then, he also wanted a path back to the project. "We felt a certain ownership over Middle Earth," he says now. "I did think it would be a decision I would regret if I didn't work with those involved somehow."