Just another two penniworth, this is an interesting thread. I used to play piano as a kid but could, and can still only play with 'the dots' in front of me, although my sightreading is pretty good I am lost without the dots.
However fairly late in life, in my early 30s I discovered folk music and was luckily enough to live near someone who taught fiddle, her main passion is Donnegal fiddling style. She taught in a group situation, workshop style by learning the instrument though playing tunes without the music. It was a complete revelation to me, and I agree with an earlier post that I am convinced that you use a different part of the brain to learn in this way. I also find that tunes I have learnt by ear I have never ever forgotten.
15 years on and I am now an avid folk fiddle player mainly in the English style. I recently found myself getting more irritated by the complete dominance of classical music at the local Saturday Morning Music School my daughters were attending, and so offered to coordinate/facilitate a folk group. I have only being doing this for about 18 months now but it is very rewarding. I teach them a wide variety of popular folk tunes often played at sessions in our area in the same way I learnt them - and still do learn them - by ear. I get the impression that learning by ear comes very naturally to children and although at first they feel a bit unsure, they soon get the hang of it. I just hope they continue to retain this ability while they are still being taught their instruments in the conventional reading-the-dots-way. Time will tell.