Did you know "needles eye" does not refer to sewing needle? I'm told it actually referred to something like a cattle gate. So the message is actually "hard but not impossible..."
According to Wikipedia, there's no actual evidence for such a gate, so this seems like apocrypha meant to soften the message.
But given that we're talking about the man who preached "give up everything you have and follow me" and "let the dead bury their own dead" I'd favor the more radical interpretation being the most likely.
It was Jesus' answer to a follower who wanted to attend a family funeral. Jesus was saying that to follow him means separating yourself from the world to the point of considering even your own family to be dead to you.
