I finally got a response from Iberia. They sent me a boiler plate e-mail indicating that "The current legislation establishes the applicable compensation and assistance that Airlines must apply " which came to 600 Euro per child.
The only paragraph that seemed that they were responding directly to our situation was the following.
"Although your children had a confirmed booking, we were unable to accept them because at the time the flight acceptance procedures were made, the number of customers with a confirmed booking exceeded the available seats. In light of this, we are applying the above regulation, which states that they have the right to compensation and that we must provide them with assistance through to the departure of the next flight."
As Dan mentioned according to Israeli law we should be getting 3080 ILS per child.
Any ideas on how to follow up at this point?
Thanks!