The lantern is in Krats' Town (Level 4 area). Use the ladder to get up on the snow and enter the house through the chimney.
My question is how did you manage to get to level 7 without it?
You need it to beat level 4, you can't get to the level 5 area without it, and you need the level 5 item to get to level 6, and you need the level 6 item to access level 7.
Edited by Smiles the Death Bringer, 24 January 2018 - 10:43 PM.