"The Source" is indeed - or at least it was - the source of all Healing that came from within Aleroth.
The Source is/was a concept that was partially abandoned during the game's development. It still exists as a kind of "game resource" (I mean the game as a program) within the game, but is unaccessible for the normal player.
The lack of Dragon Knights can be easily explained if you assume that the concept of so-called "Dragon Knights" simply did not exist during the development of the first game.
