The youngster, named locally as Preston Flores, is being treated in hospital for serious burns after the incident in Bedford Avenue in Aberdeen yesterday.
It happened after a group of children allegedly took petrol from an unattended council vehicle.
Emergency services attended the scene just before 2pm and took the child to the Royal Aberdeen Children's Hospital along with his mother.
The road was shut off to traffic as an investigation into the incident got under way.
A relative, who did not want to be named, said: "I've never seen anything so horrible in my whole life.
"I ran out and saw him running up the street in flames - they were covering his whole body.
"His clothes were half burnt off him and half sticking to him. It was awful. I was in floods of tears."
The family member said she was only alerted to what had happened after another relative banged on her door.
The blaze was put out by neighbours who splashed water on the boy.
The relative said she was getting ready to go out when a cousin banged on her door shouting that the boy was on fire.
She added: "Around 40 people ran out of their flats and started chucking water on him.
"His mum collapsed when she found out and she needed to be taken in the same ambulance for oxygen."
She claimed the children had been playing out on the road when they took a petrol can out of the back of a council lorry.
She added that the children had been "mucking about" and that she they did not know the vehicle contained petrol.
She added: "The back of the van was open and his mates were chucking petrol on him.
"They had lighters and they were sparking them. The next thing I know he is running down the road screaming.
"I think it's terrible the council just leaving it there for kids to get to. It's really irresponsible."
An Aberdeen City Council spokesman said: "We are assisting police with their enquiries and our thoughts are with the family of the boy."
Barney Crockett, Aberdeen City Council leader, said: "I feel sorry for this boy and what's happened to him.
"Obviously thoughts are with the family and the boy that's been injured. We'll have to look at things when we know more in due course."
Police officers said they were following a positive line of inquiry in their investigation, but were still trying to establish whether petrol had been used.
A Police Scotland spokesman said officers had been called out to deal with the incident along with the fire brigade and ambulance service.
He added: "Police Scotland was alerted to the incident at 1.57pm and Bedford Avenue is currently closed to traffic.
"A seven-year-old boy has been taken to Royal Aberdeen Children's Hospital and inquiries are currently on-going to establish the circumstances of the incident.
"Anyone with information and who hasn't spoken to police is asked to contact Police Scotland urgently on 101."