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Step 1: Complete the Elite Ursurper quest to obtain Philosopher stone.
Step 2: You are now able to craft using the stone.
Step 3: Kill monsters or do dungeons to obtain essence (via disenchanting green+ items), flawed shards, and stat gems (which can also be obtained with 1 jewelers kit and 2 raw iron).
Step 4: Place the item you want to upgrade in the center of the stone. Put materials on the outer ring and make sure its set to "infuse gem". Viola! Upgrading!
To simplify the "maximum potential" part. Just think of it as, the higher the items level, the higher the stats can get via enchanting.
In the 1st dungeon, there is a long hallway little bit past the 1st boss that most people skip. There is like 6 mining spawns down that path. The ONE node at the very end has a 100% chance at dropping gems.
Also, the 2nd dungeon (Longest dungeon) has 3 gem crates at the end after the 3rd hidden boss. If you don't mind a long dungeon. Lots of running.