Pretty nice so far.
The water graphics seem to cause lag on my AMD sempron 3000+ equipped PC with over 1 gig of ram.
I'd recommend optimizing all your line-art to give it a smoother allround look, and generally be more processor friendly.
Also, compared to the more shaded backgrounds, the characters look rather bland.
Other than that, the flowing river background sound effect does not seem to be looping properly. I'd highly recommend fixing that issue, also, that sound effect seems to be causing additional lag, indicating that it is likely not properly optimised. I could be mistaken on this one.
I will refraim from commenting on your current storyline, as (I hope) we haven't really seen much of anything yet.
This definitely does not qualify as a game demo due to being far too short.
The fact that not even all the features shown in the instructions section can be used, is indicative of this.
"Game engine demo" seems like a better term for this submission.
Work out these flaws and you'll have frontpage material.