Reincarnation of my grandmother      

My grandmother passed away about six weeks ago. I live about 200 miles from my family, and am pretty busy with school and raising my 2 1/2 year old daughter. I decided it was easier to leave her home with my husband and just go to the funeral myself, then it would be to try and take them with me. Despite the distance, I have tried to make it down often to see my family, so my daughter knows her great-grandmother pretty well. I've tried to explain to her that she won't see grandma again, that she died, she's in heaven, etc. I'm in favor of being (age-appropriately) honest with children, and I'm not just going to sweep my grandmother's death under the rug and pretend she never existed.
My father came up yesterday for a quick visit, and brought some of my grandmother's things for me. It was a lot of stuff. This morning, I was going through it, and organizing it. My daughter was curious about the new stuff, so I gently explained to her again that they came from grandma's house, and that she had died, which meant we wouldn't see her anymore. I asked her if she understood, and her response stopped me in my tracks. "Yes" she said "grandma died, and went away, and now she's a baby". We're not very religious, and as far as I know, she has not been introduced to the concept of reincarnation. She then picked up a marker, explained to me that grandma now had a red puppy, and drew a picture of it for me. She also told me that my grandmother lived in a small house, still lived in her mommy's tummy, and that she had two happy parents. I have no idea what to think about all this. edit: She also told me my grandma was "a boy now".