I've been pondering this very thing, but I'm opting to wait for the iPad 2 since I don't already have a netbook sitting around.
If I did, I'd keep it really simple:
1. Cloud Antivirus or something else lightweight and adequate
3. Skype for video chat with the grandparents, if applicable. Plus, it promotes pan-generational computer literacy
Mostly, I'm just going to use it to play movies/hulu/netflix on the go. I spend a lot of time in the car with my 3 year old, and it's the most productive use of her time in that scenario. Since your nephew can read, there's a lot of other interesting potential. Someone mentioned Edubuntu. I'd say just get him Oregon Trail. Or Craigslist the netbook and get him an iPod Touch.