From 3 and up, I will start to differentiate between an "imagination story" and a "really happened" story. I will hear about how the dragon came over for dinner last night and had a sleepover but had to go to the castle again, and just say "What a great imagination story that is!!".
I agree with playfelt in that it's a non-issue really until it becomes a way to get out of trouble, or to get others INTO trouble. Then we discuss the importance of telling things the way they really happen.