Traffic is encrypted as it passes through your node so nobody can view it. If you are an exit node you can of course sniff the interface (a la NSA) and see the traffic but law enforcement is aware of Tor and how it works. Watch Jake Appelbaum and Roger Dingledine at CCC kongress (29C3 i think) and they explain that because all tor exit nodes are known to the network they already have a list of exit nodes and can look it up before knocking down a door. Another point they make is that failure of law enforcement to check if they person is running an exit node could in fact work against them in court, though I really wouldnt want to be the test case...
As for the whole child porn argument, I think the technology is fundamentally awesome and necessary in the current police-excessive world, not to mention it fucks nicely with google and facebook market profiling. Of course people will abuse the technology but it isn't the tech that is bad, to massively simplify it, it's bad people using tech. Also in response to a previous post, I would imagine the fact that someone had CP on their computer would imply that person was complicit in the sexual abuse of that child, which is deplorable in my opinion. I would point out however I am not a lawyer and I hope much smarter people than me work in the judiciary...