A search on the forums should turn up many previous discussions about materials used for eyes. I know the most common suggestion here is to use golf balls.
I will add that if you're planning on selling for the kids' market then I strongly recommend you find your federal/state info on it. When I was researching I came across a lot of American info on toy product safety, so I know it's out there and easy to find. You guys seem to have a lot more requirements to fit to than us Aussies, and I won't speculate, but even though you're making puppets (and likely you won't find info on puppet safety specifically, but you will find info on toys and/or stuffed toys) it's important to make sure you're not selling anything you could be sued for.
I can't speak on selling muppet-type puppets, but I always preferred a lining. I just used a plain cotton on the inside; others might have better suggestions.
I would guess that yes people would be worried about rods. Anything sharp can poke someone's eye out. And again, this comes back to your local legislation. There may be rules about what kinds of things you can sell to a certain age. I know that here anything like my shadow puppets or a muppet-type puppet would be out for anyone under 3 years (I actually mark it up to 6 as a personal thing. I don't think anyone under 6 should use my puppets, even with supervision. Just because they're not made for that).
This brings up a concern: most people would see the more complicated muppet-type puppets for teens and up. It's partly public perception/stereotypes of what puppetry is and what age it's for, and partly the dexterity required to use the more complicated puppets. If you're really interested in selling for a younger person, why not make the puppets without arm rods, but with gloves instead? Or perhaps if you want to make them with rods, consider aiming a little higher in the age range...
The other thing with rods: I like the idea of making them detachable. The problem with my puppets is they're really hard to store with the rods (even short ones) because you have to sit the puppet just right in order not to crush the thing *and* have the rods not fit in a box with the rest of the puppet. If it were me, I'd figure out a way you can remove the rods. This makes your puppet even more marketable, because the parents who are worried about pointy things can detach the rods and keep them for later; the teens/adults who'd like your work can keep the rods; both can remove them if necessary for better storage. Don't forget that adults can get hurt too.
In this case, I don't think product safety is the major concern. I had a lot of problems selling my original puppets (shadow) because I wasn't really aware of what market I was selling to. I liked to think I was selling to people who wanted to use puppets; I ended up selling mostly to teachers. The people I need to sell to in order to make any money at all - at craft markets, etc - are people who aren't going to be doing pro performances with them. (I'd love to sell solely to puppeteers, but you really don't get very far with that without some serious commissions) The point is that if you're looking to sell stuff for parents/teachers, then you'll need to work out whether or not they'll fork out the money for a muppet-type puppet over a finger or glove puppet - the two traditional and larger selling items.
And before I sign off after rambling a bit (

), check out
http://puppetpie.blogspot.com. Stacey is a sometime member here, and she sells felted puppets. A while ago she started selling rod puppets. Might be worth taking a look at her policies - again, refer to your legislation, but it's always interesting to compare to other puppeteers and what they recommend.