I haven't gone since my son was born last year -- but I've been meaning to take him.
It is VERY VERY croweded -- yes, wall-to-wall people. But there are usually a few less crowded areas -- I've gone early & picnicked in the circle where they do the lighting (near the mall) and there was sometimes a little open area though not a ton. I don't think running & playing & dancing would work out very well.
My friend recently brought her toddler though and they had a blast. It really is fun. There is music along the river, and there are little sideshow acts (think magicians, people playing instruments solo on the side of the road, fire-eaters) that would entertain most kids (though others might be scared of them). I don't know if they still do it but Sovereign used to do a 'ballroom dancing' thing in the plaza and that was always fun (crowded on the dancefloor though).
My advice would be to go a few hours early & hang out in Providence (India Point park has a playground & lots of space to walk along the river, and Humbolt park both has an awesome toddler playground) and let the kids get their energy out & have fun. There's also the children's museum... & some splash parks (though I think they shut down at 5??) Anyway I guess my point is, if I were going I'd probably only plan to spend an hour or so at Waterfire with small kids, & then head home. I think it would be overwhelmingly crowded for them to spend much more time then that there -- unless they are still content to be worn/carried, then you could get away with staying longer!