The first mistake was having the dog on your lap. He was then alpha to the your little nephew. The second mistake was that your little nephew is nervous of dogs so your dog knows that instinctively. Your dog needs alpha boot camp.. the problem with small dogs is that everyone babies them and lets them get away with sitting on a lap, sitting on the sofa, sleeping in bed, etc... Shihtzu's are difficult dogs as they mature and not always good candidates for children of any age. I would suggest never again allowing him around your nephew or any small child as the next time the child might not be so lucky. Go back to the basics with your dog and read this article:
http://www.sonic.net/~cdlcruz/GPCC/library/alpha.htm