I know it's kind of old, but I don't really like the existing answers. They were given before the question was edited, but it appears the asker already knew what it meant, they just didn't understand how the sentence should be parsed to get to that meaning.
So, let's break it down in case anyone else happens across this question and has trouble understanding. Sorry if it's kind of long. I tried to keep it short but didn't do a great job.
Original sentence:
He was surpassed in all Hobbit records only by two famous characters of old.
Central clause:
He was surpassed.
As mentioned in the other answers, surpassed means "beaten" or "bested". The idea here is there's an imaginary contest where the winner is the tallest hobbit in the world. In this case, "he" (Bullroarer) was beaten in this contest, which means another hobbit was taller.
Prepositional phrase #1:
He was surpassed by two characters.
This is called the passive voice. The active voice is often easier to understand:
Two characters surpassed him.
Both sentences mean the same thing. Namely, that two "characters" (just a fancy way to say "two hobbits") were taller than Bullroarer, which means they surpassed him in the imaginary contest to be the tallest hobbit in the world.
The active voice (second sentence) puts the focus on the two characters, while the passive voice (original sentence) keeps the focus on Bullroarer.
Adverb:
He was surpassed only by two characters.
We can rearrange the sentence a bit to see that "only" is an adverb modifying the verb "surpassed".
He was only surpassed by two characters.
"Only" implies that even though Bullroarer wasn't the absolute tallest hobbit in the world, he was still really tall, and third place is very good considering there were thousands or millions of hobbits he was competing against in our imaginary contest.
Prepositional phrase #2:
He was surpassed only by two characters of old.
The phrase "of old" is pretty straightforward, but it's not quite the same as saying "two old characters". "Two old characters" implies the characters are alive, but have lived a long time. "Of old" means the stories of the two hobbits are very old, and generally means the hobbits themselves are long dead.
He was surpassed only by two characters who lived a long time ago.
(It's possible to have a situation where the story is from a long time ago, but the character is a deity or vampire or similar and isn't actually dead. However, that isn't likely in this case since elves are the only people in Lord of the Rings who generally live extremely long, and we're talking about hobbits who don't generally live to be much over a hundred.)
Adjective:
He was surpassed only by two famous characters of old.
The word "famous" is pretty simple here, just meaning they were well-known. There is a little nuance here, since we're not sure if they are currently famous, or were famous when they were alive, or both. My guess is they are currently famous for being very tall hobbits. But it's not really important since their fame doesn't affect the fact that Bullroarer was very tall for a hobbit.
Prepositional phrase #3:
He was surpassed in all Hobbit records only by two famous characters of old.
Taken very literally, this one could be a little tricky. In some contexts, "in all records" could mean that every single record includes a note that Bullroarer has been surpassed. For example:
In all television broadcasts, there is a three-second delay so the producer can stop the broadcast if something too graphic is accidentally shown.
In that sentence, we're stating that every single broadcast has a delay, and you might be tempted to interpret the hobbit sentence the same way. But that would be wrong.
Instead, the meaning is "if we compile a list of tall hobbits using every hobbit record as a source, we will find records of two hobbits taller than Bullroarer".
It's possible the hobbit records missed a third hobbit who was even taller (perhaps the third hobbit lived long before any existing records were written). But the sentence basically says "Bullroarer was the third-tallest hobbit to ever live".
