The Iaito is found right at the beginning of Blight Town, if you enter ia The Depths. After you kill the trolls and the five or so ettercaps/spider people on that upper platform, walk to the edge and peer out into the darkness to your leftish. You should see an item wisp on the platform below. You must run and jump to it. It took me a couple of tries. Be aware that there is an ettercap on the platform below if you fail the jump.