My five year old son is fascinated by all things small. His very favorite toys are the tiny soldiers that come with the Risk game. A friend has an ERZGEBIRGE block set that she got at Tuesday Morning for $20. It is very nice quality (except the windows could break easily). Oh, and be forewarned- you'll never get all of the blocks back into the cute wood box. You'll have to come up with another storage option :o) This would make a nice Christmas gift.
They have some fun sets- one to build a castle, etc. My little guy loves to play with it. He used some fun money from grandma and purchased their domestic living set (has windows, etc.) His favorite part of the set are the tiny one inch cubes. We picked up a few more of these at Hobby Lobby in the wood craft section.
If you can't find this German set you may want to make your own set by purchasing a variety of wood shapes and turnings. An online source is here. Etsy has some nice block sets as well. This one, Little Sapling Toys, popped out at me.If you make your own set please be careful and make sure your tiny block set will only be used by those children well past the "put everything in my mouth" stage.