Despite extensive research on storybook readalouds, the literary understanding young children construct during these readalouds has received little attention. This descriptive, naturalistic study in a literature-rich classroom investigated the literary understanding of first and second graders as picture storybooks (traditional literature; contemporary realistic fiction; and contemporary fantasy) were read aloud to them. Over seven months, data (field notes, transcripted audiotapes of readalouds, and interviews) were gathered in three contexts: 35 large group readalouds done by the teacher with the whole class; 28 small group readalouds done by the researcher with two selected groups of five children each; and 20 one-to-one readalouds done by the researcher with each of the ten children in the two small groups. Children's responses suggested five types of literary understanding: (1) making narrative meaning by "close reading" and analysis of text and illustrations; (2) making intertextual connections; (3) connecting the story to their own lives; (4) temporary aesthetic merging of their lives with the text; and (5) performative responses, in which the text was manipulated and used as a platform for an expression of the children's creativity or a carnivalesque romp. Teachers scaffolded children's learning by acting as readers; managers and encouragers; clarifiers and probers; fellow wonderers or speculators; and extenders and refiners. The role of intertextual connections was pivotal in many interpretive moves. The children learned illustrational codes or conventions and used all the visual stimuli of the picturebook (including peritextual features such as the cover, endpages, title and dedication pages, as well as the illustrational sequence) to make meaning. Individual styles of response were identified for several children. A higher frequency of personalizing responses was associated with contemporary realistic fiction than with the other genres. Two-thirds of the conversational turns took place during the readalouds, suggesting the importance of allowing children to respond during the reading of the story. A grounded theory of literary understanding was developed, conceptualizing the five facets of literary understanding as the expression of three basic literary impulses (the hermeneutic, aesthetic, and personalizing impulses) which function simultaneously as intersecting and overlapping planes in cognitive space.