I agree with your take on this rather subtle issue--your main goal right off the bat is that you don't want the 7 year old to be traumatizing the almost 5 year old (that is, a child who is actually still a 4 year old) either physically OR psychologically. The gap in age is large enough that the little guy really doesn't have an equal vote in the proceedings; he could feel over-stimulated, confused, guilty, and overwhelmed by the sexual seduction without having the presence of mind to set limits on it, and this would not be healthy for him. And too, the 7 year old could also feel, in time, worried that he might have damaged his little brother--either physically or psychologically--whether or not he actually did so. So they both need some protections from this sex play, because of the difference in age and in power.
I agree with you, also, that normal children are usually curious about sexuality and often experience strong sexual urges that they don't really know how to understand or to satisfy. Dreams, day dreams, and solitary masturbation are typical expressions of sexuality in children too young to locate, engage, and pair up with a partner. Nonetheless, many children engage in mutual sexual activities similar to what you have described, in which there can be a mixture of exploration, exploitation, seduction, excitement, role-playing, and sometimes also romantic feelings and fantasies. Families differ tremendously in the degree to which there is openness, humor, teasing, secrecy, shame, and/or horror regarding these sexual adventures of children. Individual children also differ a great deal: a timid child might not dare to even think of these things while a bold youngster may eagerly and purposefully scout around for a willing partner.
Your immediate problem is that it is difficult to deliver an awkward prepared speech about sex to your sons, completely out of the blue. On the other hand, like most parents would be, you were too astonished to discover your sons under that blanket to have your wits about you in the moment of discovery, so that the natural opportunity to respond to the specific situation has passed. The problem does not sound like an emergency, so you and your husband might consider a long-term approach and waiting for the right opportunity to discuss sexuality in its various contexts as these opportunities emerge within ordinary family life.
The balancing act is to give adult leadership and adult information to children's minds in a way that fits in naturally to your relationship with the child. By being a good observer and a good listener, you will be sensitive to what each of your son's are thinking and feeling, and can chime in to their psychological life in a way that is supportive, empathic, optimistic, and healthy. You can find the right time to re-enforce the various messages:
*Your body belongs to you and only to you, so you are the boss with your body. Don't let anyone else mess around with your body if you feel uncomfortable about it.
*Real sex is for married grown-ups.
*Don't go horsing around with your little brother's body when he's naked. He's too little for this.
*Everybody has sexual feelings, just like everyone wants to drive a car.