Several have reported about this slur being reported on the Huffington post.
IMHO, the main issue here is not the slur it represents, but the larger context behind it. the environment that produces children that engage in such behavior. To say she's not dong a very good job disciplining the child is an understatement. More likely he is merely modeling behavior he's seen or heard from his parents/grandparents. Granted the the boy is really too young to understand what he actually said. So he's using a term he's heard elsewhere, not likely from TV, but more likely a term used by his family.
You see, the problem isn't just that he's heard someone else use the term. The larger problem, is that it's obvious he's heard someone else use it in regards to his aunt. He's saying mean things to her, and it's obvious he said it with the intent to hurt her. He may not have known what it means, but he knows it's used by others to say bad things about his aunt.
Bristol's reaction is even worse. She obviously knows who's used the term before, and actually thinks its quite funny. If she's embarrassed it's only b/c she can't believe he used the term on camera. Her voice over was probably added in later when someone explained to her how bad that will look on TV.
As many have said about this incident already, these people are awful people. But this incident is more than just the Palin's behaving badly, it's an illustration of children modeling/emulating the behavior of their caregivers and other supposedly responsible adults that surround them. It's a microcosm of what's wrong with intolerant behavior in this country.