You guys are talking about diffraction like it is a big issue with smaller format sensors.
Yes, it comes into play at sooner and larger apertures but a smaller format has an inherently larger DOF anyway. Diffraction is overhyped. If you really need the DOF, you shoot at the highest aperture you can anyway.
In the end, you usually end up with a similar DOF on most formats before running into diffraction.
Try shooting 4x5. You can get super shallow DOF anytime you want but in order to get a broad DOF I find myself stopping down to f/32 and up. At f/64, I am seeing quite a bit of softening due to diffraction. I would compare it to shooting at f/22 - f/32 on 35mm.
It is all relative.
What DOES come into play are the lens apertures required to achieve a shallow DOF on a given format. A lens with an f/0.xx (whatever) aperture is going to be quite difficult and expensive to make. Not to mention, there aren't many 35mm camera mounts that would support a lens with an aperture larger than f/1.0. Canon had an f/0.95 lens at one point a while back (IIRC) and more recently a 50mm f/1.0 before they replaced it with the 50 f/1.2.
Stepping back...
All I am trying to say is, diffraction is relative to pixel pitch and in effect, sensor size but DOF is also relative to sensor size. So in the end, just keep in mind at which apertures diffraction starts to affect your images and work around it. It's a good thing to consider when shooting at smaller apertures. A good photographer knows the limits and abilities/strengths of his/her equipment.
The average consumer doesn't even know what diffraction is (let alone be able to recognize it in any of their photos) so it doesn't really matter anyway.
To the OP:
I am sorry for so much geek speak!
I DO want to say that all this techno babble about sensor size
does matter. For a given sensor technology, a larger sensor will always be superior to a smaller one.
You are collecting light first and foremost. A larger area collects more light and so will larger pixels produce a stronger signal to noise ratio = cleaner, more efficient pixels = more leeway to brighten your photos up and still retain a clean image if you screw up your exposure. It also means, that in lower light situations, (such as a gymnasium) your larger pixels are capturing more light and producing a better, cleaner image than that of smaller pixels. Most of these cameras have equal MP counts which means the sensor size determines how packed in they are (or how spread out. Half full, half empty...)
Of course, there are more benefits than that but these are things that might matter to you.
And YES. PLEASE look at lens selection before buying a camera. The kits might look great but picking up any other lens could prove to be difficult and/or limited. Check the used market.
Also, the 18-200VR lens that Nikon makes is NOT that great. It has ok build quality and a reasonably fast AF motor. Think of it this way... It is hard to manufacture a lens to be good at all of the focal lengths from 18-200mm. For what the range it covers, it is one of the best out there. BUT, it does a whole bunch of things at a mediocre level that a few individual lenses could do really well. The aperture is slow which will hamper your indoor shooting. An f/2.8 zoom might be better suited or you could look for a fast prime such as the 85 f/1.8. BUT keep in mind. If you go with Nikon, you will have to buy a D70 (incl. D50) or higher model for the lens to AF. The D40/x does not have the old "screw" drive AF motor in the body. A Canon Digital Rebel might be better for this scenario. Canon makes a very fast focusing 85 f/1.8 that can be had for ~$370 + or - depending on where you look.
Just so you know, the word on the street is Nikon is going to release an updated AF-S (means it will focus on the D40/x) 85 f/1.4 but nobody knows when. Might announce it around Jan/Feb along with some other lenses and maybe a body. Availability is usually a 2-3 months after announcement. I wouldn't recommend putting off shooting for that long while waiting for vaporware.
My opinion?
Nikon is awesome. Canon is awesome. Pentax is alright. All the others aren't worth looking at yet.
...but that is just my opinion.
Sorry for being so long winded.
-EDIT-
*BTW, for those that have knocked Live View. I absolutely LOVE it for studio and macro work on my D3. The ability to zoom in on the area you are focusing on and be able to see EXACTLY where the focus plane is falling before you take the shot is AWESOME. I'm not sure if this capability to zoom in during live view exists on the Oly cameras though.