My four-year-old and I "write" a story every night. She dictates; I scribe. It's so funny. She usually ends up retelling fairy tales, but she puts her own twists on them. She also illustrates the stories. I can't wait to make copies for the family at Christmas time.
I also keep a HUGE stack of magazines, safety scissors and glue sticks readily available for both of my daughters (12 and 4). We make collages all the time. IT keeps them both busy for hours.
We also keep a huge trunk of dress-up clothes. You can get cheap stuff from thrift stores or ask family members. To be honest, all you really need is a trunk of hats. Hats give way to new personas. My daughter plays dress-up all the time. Some times I even take her to the store in her fairy wings.
We also read. I think reading is the number one thing a parent can do to foster imagination.
In the summer, we keep an easel on the deck. She goes out in her painter's t-shirt and paints and paints and paints. Use non-toxic stuff (duh - I know) because my daughter often ends up painting herself.
Have whopper-telling contests. Let your 7-year-old be the judge or dad or the dog!
Play the Word Association Game (a game for ALL ages.) This is where you say a word and then the next person has to say a word that is somehow associated with the original word.
For example, you might start out by saying "Baseball" and your son might respond with "Bat" then you might respond with "Vampire," and so on.
I think just keeping his mind going is what's important. The best thing is that the above activities are free or very affordable. Most imagination-stimulating activities are.
Above all, keep the video games in the closet and the TV off! Nothing kills imagination faster than those two things.