Ending of SoMI is rather legendary - Guybrush and LeChuck are revealed to be small children playing in an amusement park, and parents take them away. However, LeChuck’s (“Chuckie’s”) eyes flash and he appears to be doing some magic, leaving room for doubt that there’s something more than meets the eye going on here. And in the start of CoMI, Guybrush is floating in a bumper car, and we’re (to my memory) never really explained WTF happened.
So, WTF happened?
The ending you refer to is actually the ending to Monkey Island 2: LeChuck’s Revenge, and the ending event is referred to as “The Carnival of the Damned” by LeChuck in Curse.
I can’t elaborate anymore, though, as I forget.
[slight hijack]
Anyone notice the ending to Austin Powers in Goldmember bears a slight resemblance to the ending of LeChuck’s Revenge? Albeit slightly more “happier” and minus the carnival atmosphere
[/slight hijack]
I could have sworn there was a flashback a little way into CoMI that explained that…
In both sequels to LeChuck’s Revenge, i.e. Escape from… and Curse of… it is sometimes referred to, mysteriously, in a “What the hell was that about?” vein. It’s never satisfactorily explained, except to say it wasn’t a dream, it was a deliberate illusion to put Guybrush under a false sense of security.
At least, I think that’s what it was. I should play them all again to remind myself.
(Coming soon, Beneath Monkey Island, Return to Monkey Island, and the reimagining of Secret of Monkey Island directed by Tim Burton) 
Towards the end of the game, Guybrush is captured by LeChuck and held in a skyway bucket while LeChuck delivers all the exposition.
He’d built a carnival to lure sailors & their families and turn them into undead warriors. When visitors to the carnival ride on the giant roller coaster, they’re plunged into lava and turned into skeleton pirates. He built it on Monkey Island because everything in the park is monkey-powered. In Monkey 2, he’d cast a spell on Guybrush to disorient him and make him think he was a little child – it’s never exactly explained why, but it’s implied that it was to keep him out of the way.