Proof.
We apply More on Morphisms, Theorem 37.53.4 to get a Stein factorization X \to X' \to Y. Then X \to X' satisfies all the hypotheses of the lemma (some details omitted). Thus after replacing Y by X' we may in addition assume that f_*\mathcal{O}_ X = \mathcal{O}_ Y and that the fibres of f are geometrically connected.
Assume that f_*\mathcal{O}_ X = \mathcal{O}_ Y and that the fibres of f are geometrically connected. Note that y \in Y is a closed point as f is closed and E is closed. The restriction f^{-1}(Y \setminus \{ y\} ) \to Y \setminus \{ y\} of f is a finite morphism (More on Morphisms, Lemma 37.44.1). Hence this restriction is an isomorphism since f_*\mathcal{O}_ X = \mathcal{O}_ Y since finite morphisms are affine. To prove that \mathcal{O}_{Y, y} is regular of dimension 2 we consider the isomorphism
\mathcal{O}_{Y, y}^\wedge \longrightarrow \mathop{\mathrm{lim}}\nolimits H^0(X \times _ Y \mathop{\mathrm{Spec}}(\mathcal{O}_{Y, y}/\mathfrak m_ y^ n), \mathcal{O})
of Cohomology of Schemes, Lemma 30.20.7. Let E_ n = nE as in Lemma 54.16.3. Observe that
E_ n \subset X \times _ Y \mathop{\mathrm{Spec}}(\mathcal{O}_{Y, y}/\mathfrak m_ y^ n)
because E \subset X_ y = X \times _ Y \mathop{\mathrm{Spec}}(\kappa (y)). On the other hand, since E = f^{-1}(\{ y\} ) set theoretically (because the fibres of f are geometrically connected), we see that the scheme theoretic fibre X_ y is scheme theoretically contained in E_ n for some n > 0. Namely, apply Cohomology of Schemes, Lemma 30.10.2 to the coherent \mathcal{O}_ X-module \mathcal{F} = \mathcal{O}_{X_ y} and the ideal sheaf \mathcal{I} of E and use that \mathcal{I}^ n is the ideal sheaf of E_ n. This shows that
X \times _ Y \mathop{\mathrm{Spec}}(\mathcal{O}_{Y, y}/\mathfrak m_ y^ m) \subset E_{nm}
Thus the inverse limit displayed above is equal to \mathop{\mathrm{lim}}\nolimits H^0(E_ n, \mathcal{O}_ n) which is a regular two dimensional local ring by Lemma 54.16.3. Hence \mathcal{O}_{Y, y} is a two dimensional regular local ring because its completion is so (More on Algebra, Lemma 15.43.4 and 15.43.1).
We still have to prove that f : X \to Y is the blowup b : Y' \to Y of Y at y. We encourage the reader to find her own proof. First, we note that Lemma 54.16.3 also implies that X_ y = E scheme theoretically. Since the ideal sheaf of E is invertible, this shows that f^{-1}\mathfrak m_ y \cdot \mathcal{O}_ X is invertible. Hence we obtain a factorization
of the morphism f by the universal property of blowing up, see Divisors, Lemma 31.32.5. Recall that the exceptional fibre of E' \subset Y' is an exceptional curve of the first kind by Lemma 54.3.1. Let g : E \to E' be the induced morphism. Because for both E' and E the conormal sheaf is generated by (pullbacks of) a and b, we see that the canonical map g^*\mathcal{C}_{E'/Y'} \to \mathcal{C}_{E/X} (Morphisms, Lemma 29.31.3) is surjective. Since both are invertible, this map is an isomorphism. Since \mathcal{C}_{E/X} has positive degree, it follows that g cannot be a constant morphism. Hence g has finite fibres. Hence g is a finite morphism (same reference as above). However, since Y' is regular (and hence normal) at all points of E' and since X \to Y' is birational and an isomorphism away from E', we conclude that X \to Y' is an isomorphism by Varieties, Lemma 33.17.3.
\square
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