So sorry for both of you....
My grandfather passed away last summer, when DS was 2.5. I had no idea what to tell him and our pediatrician said, "Tell him the truth, and keep it simple. Just tell him great-grandpa died." She said most kids will not quite get what that means, but accept it as the answer and figure out that it means we won't see the person anymore after awhile.
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This did not happen with my son, but maybe b/c I told him other things first (only asked the doctor after he kept asking "WHY?" when I told him Great-Grandpa didn't live at the hospital anymore and we couldn't visit him). I tried my best to explain that his body was old and broke, and couldn't be fixed, so he decided he didn't need his body anymore and now he doesn't have one. (We are not religious, so going to live with Jesus wouldn't have helped him understand, but I think that's a great explanation, and also a reason to be happy for the person in addition to being sad for yourselves...) After a few weeks, he stopped asking.
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Last week, he saw someone in a wheelchair and asked what Great-Grandpa is doing. Then he asked if we could go visit him in the hospital, and I reminded him that he's not there anymore, and that's why we haven't seen him in a long time. He asked why, and I said, "He died, remember?" He said yes. We talked a little bit about being sad that we can't see him anymore, but glad that he's not in any more pain, and by the time that little bit was said, DS was distracted by something else and let it go.
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Sorry for the long post, I hope it helps. I think the key is to be very open, and share both your sadness and your happy memories. It might confuse the little ones that you're sad and happy at the same time (or at least talking about sad and happy things together) but I think it's a relief for them to know you're not just going to be sad all the time from now on.
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ETA: Springmum, does your local library have a children's librarian? Ours was able to recommend a book (can't remember the name of it, sorry!) for DS. It was about a boy who loved his dog, and the dog got old and started to slow down, and then passed away. Very short, glosses over a lot, and really wasn't helpful to my son, but might help a child who is a bit older. I wish I had borrowed the book when my grandfather went into the nursing home, so that DS would have been able to draw some parallel to the changes rather than relying on hindsight and the memory/comprehension of a 2-year-old...