I heard of the said entity from a psychology class... we were discussing Descartes and the "Cartesian Theatre" concept. The homunculus was explained as an audience member (well, actually, the audience member, proof that your life is boring as hell). The play going on would be whatever the senses gather from the outside world. Thus, this symbolism is the metaphor for the projection of what the body senses onto the mind; very much the Freudian Ego.

But then, if we say this is an accurate representation of the relationship between mind and body, we must account for the homunculus' senses and the homunculus' mind, and thus we have another Cartesian Theatre within the homunculus, et cetera ad infinitum. Although this creates a significant problem in the logic of the concept, a more neurologically-informed person will know that information from the senses does not collect in one central area to be processed; the human brain (or for that matter, any organic brain) is a haphazard assemblage of neurons, like a monstrously huge and intimidating knot. An accurate equivalent of this would be the worst spaghetti code known to mankind. Thus, not only does this concept seem logically impossible to an inhabitant of the Eighteenth Century, but also neurologically impossible to the modern person.