This is a common question young children ask - and usually it's when parents are not prepared to provide a answer.  While many explanations and analogies have theological cracks in them, here is a good one to keep in your arsenal.

The ants.

Imagine an anthill with ants coming and going. Now, imagine standing next to the anthill watching the ants as they work, walk in lines, and carry things.  The ants can't see you, you are too big.  All the ants see is their world, the other ants around them, little tiny pebbles, and leaves.  Ants eyes are not capable of seeing a person, they weren't made to see anything that big.  However, just because the ants eyes won't let them see you standing next to them, doesn't mean you aren't there. 

That's kinda like God. God is so big, we can't  see Him.  We're like the ants; all we see is what is around us. God is much bigger. He's right next to us; and He sees everything around Him, while we only see the anthill. 

Keep in mind: This is a word picture to help kids grasp the "bigness of God" and  that God is Spirit and people are of flesh and blood, just as people and ants are made differently.