My 3 yr old ds has always been fascinated with his penis and fiddles with it constantly. Until quite recently, he would sit on my lap nursing and fiddling till he got an erection, but I told him that it wasn't something we played with while sitting on mummy's lap and he stopped.
Tonight while in the bath with his baby sister he was lying back and letting her fiddle with it and I told him to sit up so she couldn't, because it's only something that he can touch.
Dh thinks I'm setting him up for a huge complex, and that we should just ignore it, but I think it's perfectly natural that he wants to play with his penis, but he should learn to do it in private.