I need to sharpen some Forster bits, which are made of steel. What is best to be used and is there a proper way of doing it? Some people use sandpaper and others say diamond. Could I use the sandpaper on this or am I better off with using my diamond files?

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I don't think you can sharpen a Forstner bit accurately enough with abrasive paper. Even if you glue it to a small slips of wood to make rudimentary files from it these won't be particularly stiff so may not give you the accuracy you'd want to properly sharpen a bit, where as much as possible you want to maintain the existing geometry of the factory grind. It is possible in theory however.

The traditional tool for sharpening bits is a type of file, although with Forstners a round slipstone was often a necessary addition to tackle the bevel on the curved rim.

These days in place of a round slipstone many use a conical burr chucked in a pillar drill or a Dremel-type tool, or any similar handpiece. And for the flats a small slipstone can also be used, but it's commonly done today with a fine diamond paddle.

Although bits are usually made of tool steel they're not generally hardened to the same level as other cutting tools so can usually be comfortably cut with a steel file, just as with augur bits used with a brace.

Consequently the whole job can in theory be done just with files, a set of needle files being sufficient as long as they're of decent quality.... no guarantee of this today unfortunately! Price is not a reliable guide to quality with needle files, some cheap ones are well shaped and the toothing is cut well, while you'll read customer feedback on many files that cost more which indicates they can be neither. So I would recommend inspecting before you buy if at all possible. For a Forstner bit you'll need at least the round (rat-tail) and a flat or tapered file (the flat side of a half-round), and a triangular file may prove useful too.

If your bit is better made it may be hardened or made from a harder/tougher alloy such as HSS in which case they will probably not cut well enough with needle files so any of the alternatives will have to be used instead. It might seem obvious to use diamond needle files here, but IME many common diamond files are much too coarse for this job (150-300 grit, where you want something like 600 grit or finer).

Just as with augur bits you must be careful to sharpen only certain surfaces on a Forstner bit. The rule with large round bits like this is never to file the outside or circumference or you'll change the bit's size. While this is itself a problem there's more to it than that, it can also make the bit cut much less well and can lead to burning of the stock or worse, jamming, due to the cutting edges being a smaller diameter than the body of the bit.

For a Forstner the process is essentially this:

  • hone the bevel on the edge
  • hone the straight flutes or chip-lifters
  • hone the central spur.

Just to show the basics:

Forstner sharpening

More detail is particularly useful here so here are links to Forstner bit sharpening info online:
An animated GIF showing the rim being sharpened with a file.
Forstner Bit Sharpening Kit Instructions on Rockler.
Conventional Forstner Bits on Highland Woodworking.
How to sharpen Forstner bits from Wood magazine.
Sharpening Drill Bits on Workshop Companion (also covers other bits).
Forstner speed and feed chart with sharpening instructions, originally supplied with a set of Forstner bits.

Remember the rule: little and often. As with all tools it is better to do minor touch-ups periodically than to leave it too long and then have to do major sharpening. A blunt Forstner bit won't cut clean, neat holes like it's supposed to and could be hazardous to use.

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