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Found inside a chest in the southeastern chamber in the Tunnel of the Founders beneath Vergen. The sword is in a chest guarded by a Bullvore (see map below), and, in the Enhanced Edition, both paths can get it. If you side with Iorveth at the end of Chapter I, you can obtain the sword at any time before entering the cave with Saskia on the Xbox version. If you side with Roche at the end of Chapter I, the sword can be obtained during Hatred Symbolized while on your way to meet up with Saskia and Zoltan.
For the PC version (any of them), it is not possible to get the Blood sword on Iorveth's path. The portions of the Tunnel of the Founders where the sword is located is inaccessible.