Well, if that happens on the province level that would represent one of the races beating in the heads of the other and dominating the province. Character-level conversion would be a bug.
Do the dwarves have any mechanics for reclaiming lost holds? Any events or the like for restoring lost bits of their empire as well?
Once you give a feudal lord a title they will automatically become Urban Feudal (as long as they are not too foreign).
However, there is a bug that prevent Urban Feudal or Imperial government lords from giving kingdoms to non-same gov rulers, so you need to either use the console, or add can_grant_kingdoms_and_empires_to_other_government = yes to their sections under in the feudal_goverments file.