Montessori says to let the kids use a REAL needle, but you'll have to supervise. You could use stiff, loosely woven cloth (gah! I can't think of what it's called, but it's mentioned in Mntessori Play and Learn by Britton, which is a great resource for 2-6yos) to make it a bit easier to push the needle through.
I like the Minnow Knits stuff by Jil Eaton. Many are simple, and she has how-to-knit stuff in them, BUT the 1st book (entitled simply Minnow knits) was poorly edited, so some of the patterns have mistakes in the directions (ok for an experienced knitter, but would drive a newbie nuts). I also have Melanie Falick's Kids Knitting, which is great! Public libraries may have these books, as well as other kid-books on learning to knit (which are a wonderful resource for simple stuff). Try making scarves, beanbags (line them to keep in the beans; later you can use them to learn to juggle), a square purse/tote for dd (maybe she could fingerknit a shoulder strap), doll blankets, dishcloth (use heavy cotton yarn), bathtime washcloths for dd (get wild colors -- they may fade a bit in the water, which may be even more fun!), a hat (knit a big rectangle, sew it into a tube, tie one end off with string -- maybe fingerknitted, add pompoms).
Bekka, I loved hearing about your dd. My 26mo old was stringing pony beads onto pipecleaners the other night, totally absorbed in it for about 45 mins. I'm going to try your project with her!