problem #1 is that there are not enough seams. If you can't make the UV islands out of real paper and still be able to wrap it around a real model; then you are going to have problems trying to do this with computer art.
The texture will be stretched to the point where some parts of it will have a high resolution and some parts may be low enough that all you will see in that area are pixelated artifacts.
After adding a texture, you can change the type for visualization purposes. The texture for the next few steps is a checker texture that allows you to see if the UV's are mapping to the model well.
It's a good idea to repeatedly toggle the SubDivide UV's option for the generative modifier to make sure nothing weird is going on here. OpenSubD is supposed to correct this issue but it has not been implemented yet. ;)
Also, you can toggle the modifiers visibility on and off to look for potential problems that should be corrected.
In the following .gif animation, there is some minor distortion when the modifier's settings are toggled.
If you see any obvious stretching when toggling a Sub-Division modifier, you can sometimes correct this by adding a control loop near the area that is being affected.
The following animation shows the difference before and after a control loop is added to the wrist area.
The ears have no seams along the sharp edges which flow along a curve. This area will be distorted.
Uv islands should have at least a few pixels between them and if you zoom the UV Image Editor in and out, you should be able to see a clear distinction between the UV Islands for all distances that the model may be viewed at.
If the edges appear to be in the same place visually, then texture Mip-Mapping will shows artifacts along the seams when the model is zoomed in and out of the 3D Viewport.
The various UV Islands will bleed color into one another at the seams. Normal maps will exaggerate these errors.
A Margin of 0.01 is a good place to start. This factor depends on how many Islands there are and how big the texture is and the models position relative to the view position, scale, etc...
There are settings for both Blender Internal and Cycles that must be set when using normal maps. In BI, the Image Sampling Normal Field must be set. In Cycles, the texture node should be changed to Non-Color. The normal map will look broken if you forget this step.
Here's the final result.(Right-click the image and choose 'View Image' to see the larger version.)
The following link shows a turntable animation hosted on Vimeo. (I get an invalid certificate warning from this link. Vimeo should be safe I think?, could be a mistake)
Here is the .blend file. http://www.pasteall.org/blend/35226
And some further reading on the topic. How can I bake textures on uneven goemetry without tearing and stretching