First, buy them a few tools: hammer (7 oz.), saw (Stanley has a good toolbox saw that's short), square, screwdrivers, tape measure. Then, the first two projects are a toolbox and a workbench, either order. I bought a 'carpentry for kids' book (don't remember the exact title or author, but there were several similar books at the bookstore). It has good simple designs for the toolbox and workbench. Depending on your budget, you can get them a brace and bit(s), or you can drill any holes they need.

Now although this is more carpentry than woodworking, I found it to be a good introduction to using tools safely, and to get them thinking about how things are built and how to plan a project. This past summer they built a tree fort and a go-kart (old lawn-mower wheels) with very little help from me.

For my 7 year-old's birthday, I bought him a woodworking combination 'tool' that works quite well with balsa wood. Although this is more like a toy than a tool (it cost about $35, runs on 4 D-cells), it has a lathe, drill press, disc sander, and jigsaw. It's been a great/safe introduction for him into working with wood that's less than 1 1/2" thick and cut at something other than a right angle. His favorite project is a paper airplane stand, which is a turned dowel that's glued to a flat base and slotted on the other end to hold an airplane.