Steve and I have finally started watching The Lord of the Rings with the kids. I have only been waiting to do this with them since before they were born.
They haven't seen or read any of Tolkien, so they went into this without any background knowledge (other than a general feel of how fantasy stories work from other series and films, which does help), but they've followed it pretty well actually. Given their untrained status, though, we're starting with the theatrical releases. Extended editions are a bit much to spring on someone the first time through.
During Fellowship, they were totally not taken in by the fall of Gandalf. One was all, "He'll use his magic to come back," and the other was like, "Totally." Then our younger kid perkily said he'd like to be the Balrog next Halloween.
Last night we finished The Two Towers, and they agree that the Ents trashing Isengard is one of the most satisfying things to watch ever. It then occurred to us to wonder: what would happen if Treebeard took the One Ring? My first flippant thought was, "Moss and lichen on EVERYTHING," but actually (of course) it turns out there is a long and interesting fan discussion about this already.
Also, I managed not to break into song at "They're taking the hobbits to Isengard!", but it took effort.
Bonus material: our younger son doing his Gollum impression.