Where this idea started—and why it was readily believed—is hard to pin down. A 10th century Byzantine encyclopedia called the Souda has an entry that "every seven years the Jews captured a stranger, brought him to the temple in Jerusalem, and sacrificed him, cutting his flesh into bits." A 5th century story by Socrates Scholasticus
Some thought that the Jews were recreating the Crucifixion, but stories of Jews sacrificing non-Jews are older than Christianity. The 1st century Greco-Egyptian writer Apion told the story of Mithridates entering a temple in Jerusalem in the 2nd century BCE and finding a Greek held captive who explained that he was being fattened for sacrifice.
Blood libel accusations in medieval Europe increased at the time of the Crusades, when pro-Christian/anti-Jewish sentiment was spiking. The Crusades also included attempts to force conversion on Jews which were countered by Jews killing their own children to prevent them from suffering conversion. If Jews could kill their own children, the thinking went, then they would have no trouble killing others' children. (In fact, collective homicide/suicide goes back to Masada and was seen more recently—"recent" compared to the Hugh of Lincoln incident, that is—in the Clifford's Tower incident.
There was, of course, a known precedent for Jews to cause children to bleed, and that was the bris, the circumcision ceremony. One such ceremony was tied to another accusation of blood libel. As grisly as the concept is, I want to give some more examples of "little saints" like William of Norwich and Robert of Bury. First, however, let's discuss the case of Harold of Gloucester, where the accusation led to no real action except to...finance a war? I'll try to make sense of that tomorrow.