First, we need to look at the rules for cover:
Cover (-2 Penalty to Attack Rolls): The target is around a corner or protected by terrain. For example, the target might be in the same square as a small tree, obscured by a small pillar or a large piece of furniture, or behind a low wall.
And creatures and cover:
Creatures and Cover: When you make a ranged attack against an enemy and other enemies are in the way, your target has cover. Your allies never grant cover to your enemies, and neither allies nor enemies give cover against melee, close, or area attacks.
From this, as allies only provide cover for ranged attacks, not for everything, as proper cover does, there is a strong suggestion that allies do not provide sufficient cover for stealth in this instance. Even the feat "Killer in the crowd" does not suggest sufficient cover from some enemies to provide cover for hide.
In a practical note, as this would necessitate calculating sight-lines from all enemies to the gnome, the gnome would only be able to hide from some enemies using this trick, and it would severely complicate the start of combat.
Therefore, as allies only provide cover against ranged attacks (and not, for example, melee attacks with reach) and the complexities involved in determining cover at start of combat, my answer is: "Allies alone do not provide sufficient cover for reactive stealth."
My recommendation is to carry an enshrouding candle, as a level 7 item it is a great portable source of unlimited concealment.
There have been many discussions on this topic: here(2008), here(2008), here5, here(2009) and here(2010). There is no consensus, and the stealth rules have been changed often enough to obsolete the earlier threads. This is something that you should ask your DM about.