New York Times, "The Neuroscience of Your Brain on Fiction" cited current research on what happens when we read (or listen to) fictional narratives. You may recall I wrote an article back in December in a similar vein, This Is your Brain on Stories. Again, it has been shown through fMRI scanning that reading words associated with sensory or motor activities stimulates not just the regions in the brain that are related to language processing, but to the specific sensory or motor activities being referenced. Stories thus act as simulations of activities or events, giving us the chance to live an experience we haven't yet had. Scientists also speculate that lots of experience with fiction, with its rich metaphors and descriptions and exploration of character's thoughts and emotions, helps to develop "theory of mind." This is what helps us imagine what might be going on in someone else's head, and gives us clues about how to proceed in social interactions.
The article does specifically mention how this affects children: