Of course kids play Super Smash Bros when they all get together. It’s a PARTY game. That’s what it’s for.
Anyway, I don’t really have any solid advice on this topic, except for a couple of snippy caveats - the list of games for 360 (and PS3) only contains retail titles; Since both Xbox Live Arcade and PlayStation Network feature large numbers of downloadable titles (some of which are very high quality) a significant number of which offer at least 2player support. (Castle Crashers, of course, offers 4.)
That whole debate may well be beside the point judging by the age spread of your children - I doubt that the 12 year old is going to be spending lots of time playing games with/against the 5 year old, so full 4 player support probably isn’t really relevant. Though I suspect (and cannot prove) that there are probably ways to manipulate the online play features of the PS3 and/or 360 to play only with friends. Or maybe that’s my old PC gamer self talking, but it seems like an obvious parental control to me.
Similarly, I can see both sides of the “get what their friends have”/“get what their friends don’t have” discussion - I experienced both growing up, and I can’t honestly say if one was innately better than the other. The fondest memories I have of playing games with friends were A) Usually single player affairs where one person played and the other person watched, then they switched and B) directly related to the quality of the GAME and not the system.
So I’m going to float a new idea. You may or may not be a gamer, your post doesn’t say, but if you are, you probably already have an idea of which system you’d like, and if you’re not, you’ve staring down the nose of a fine opportunity to try out the hobby. In fact, I strongly recommend that, as a responsible parent, you put in at least some time with any game you’re going to let your kids play, so you might as well enjoy it while you’re at it. So do some research. Find some games you’d like to play. If possible, find someone who already has them and will let you play. Buy a system that you will enjoy. There’s no point in dropping $300+ on something you won’t enjoy, because, frankly, when you get down to it, most kids aged 7-12 will be entertained by pretty much any system you can buy these days, assuming you get a decent spread of games. (Which, truthfully, I feel is easier on the 360 or PS3).
Oh, and for full disclosure, I own a 360. I have a couple of friends with Wiis, but truthfully, the desire to actually own one faded away pretty quickly after playing with them for a while. I have… never actually even seen a PS3 outside of a display at Best Buy or the like.
All the Wii games mentioned are age-independant, in terms of content I mean. I’ve never played any of them with a 5 year old personally but I know a lot of gamers who started with Mario and Pokemon at that age.