According to the DVD it was a combination.
At some points they used children to play the hobbits, this worked when they were being shot from the back or from a distance. At other times it was trick photography - usually forced perspective like you describe. (They used this when Gandalf was in Bag-End for example). At still other times it was computer aided effects.
As always with movie effects, Peter Jackson and team didn't stick to one type of effect for long. It's easier to fool the eye if you change tricks mid-scene.