From what I understand, it's a very Finnish (Scandinavian?) tradition to use elves around Christmas time to keep your children in line. As in, the elves are watching and reporting to Santa, so you better be good...
This year we are starting a new tradition. The elf on a shelf is coming to live in our house. Every night in December, he will report to Santa about the kids' behaviour. When he returns in the morning, he will choose a different spot for observing the kids. When the kids wake up, they will have to find the elf. I think they'll love it. We'll see.
ps. I found the elf and story book at Chapters.