I think they mean that you have to convert the dialogue into indirect speech and then write it in paragraph form.

Helen asked Mr. West what had happened to John. He told her that John had left the company. She asked him why he had done that. He replied that John had asked him for a rise, but he had not given it to him. Helen asked why he hadn't given him a rise. Mr West replied that it was because John had been lazy. Helen asked if John had found another job. Mr West replied affirmatively and said that he was working in a film company. Helen asked what his salary was like. Mr West said that he thought John earned quite a lot. Helen asked if he liked the new job. Mr West replied that he did not know.




Not sure if there should be so many short sentences though (they're disconcerting, to say the least), or if we can join two or more of them together.