Hello @Maxine33
The correct thing to do, and it would be of benefit to all lies in your initiative to refer them to other listings in the area.
I'd have been inclined to have suggested they may like to check out other near by listings for the additional Guests so they can all pop around and meet up in local parks, cafes, pubs etc for their entertainment and family gatherings.
One can understand with children they need outdoor spaces to run around, as children have been quite damaged with the current 'Climate Change'.
They will be looking forward to seeing their own age or similar relations as children do.
Maybe they haven't had holidays together for a while with all the Restrictions imposed and through talking with excitement of a pending holiday ( understandably so ) they decided to have a reunion that perhaps has escalated that they to were not sure how to address.
It can be very challenging when it comes to Family gatherings as some families are larger than others for whatever reason and we need to be understanding of those needs to.
It would be good if you could all come to a happy compromise and win win without the loss of the booking.
Think how you would feel as a child having the disappointment of seeing photos of a Holiday Home and hearing they were going on a holiday taken away from them, if you both end up cancelling.
I'm sure they will understand local Ordinances as @Emilia42 has pointed out.
All the best and embrace it positively, without the loss of your original reservation, who I'm sure will understand when it's explained.