Should I sue or not?

That's a tough call. If it wasn't for commercial use, I would say don't waste your time. But, as you point out, it is for a magazine that actually costs money.

I think what you have to take into account is this:

1. Suing people costs you money/time/headache.
2. Suing people makes YOU enemies (even if you are in the right - which I think you are).

Are both those worth it? I just comes down to how much you care.

Obviously I am no lawyer, but I would guess that step 1 wouldn't be to sue anyway. Probably it would be an official communication to them indicating that they have used copyrighted material without permission. One would hope that once this mistake is indicated to them they would work to resolve it without the need of a lawsuit.

I would pursue something if only because the principal is an important one.

I'd email the magazine - explain what happened and ask if they can print a correction in the next issue with your name, URL, etc. Keep it positive.

As Ben says - suing anyone is going to be expensive...

I used to work for a large magazine house, and they're generally pretty up on the fact that they need to pay for images, mostly because they've been sued before. Most likely someone junior has dropped your image in thinking it will never matter. Send the editor an email or call the magazine direct, explain the situation, and you're likely to get a decent response.

As the others have said, I wouldn't ignore it. On the other hand, I also wouldn't even mention the s word to begin with.

Just write a polite letter or email pointing out their error and offering them a way to make you go away - do you want them to print a correction crediting you with the image? Do you want to be paid? If so, what's a fair rate? Don't be greedy, at this stage you want them to choose to do what you ask because it's the easy option for them. Sueing should be a last resort because it's expensive for both of you.

If it all goes well, you may even get some future work from them - it's happened to me before.

I recently had a friend who unknowingly used a copywrited image for the header of a website he built for a client... Even though he only used a cropped portion of the image, he was still held liable for copywrite infringement and had legal action taken against him by the owner of the image. The process was quick and he settle out of court with the photographer for 15k (they originally were seeking 19k). I definitely think it is worth your time to pursue the issue further, the headache is handled by your lawyer (thats what you are paying them for) and the payout could far exceed the legal fees (even more so if they settle out of court).

I just want to thank everyone for their replies.
I will update this page as things develop.

I'm a working press photog here in Canada. Although it's a great idea to play nice with someone who has stolen from you - it really doesn't work in the long run.
Publishers sell ads (and maybe subscriptions) to generate a profit for their companies, if they can get away with *free* content ("send in your photos and stories and we'll print them") then they'll do it. Of course, adequate compensation is not a credit/URL, but should include at the very least a licensing fee for their use of the photo.
Bottom line, if they can afford to go to press, and printing four-colour process isn't cheap, then they can afford to pay a licensing fee for your photo.
On a sidenote; Freelancers in Canada are faced with this every single day with the combining of entities under massive corporate umbrellas. We have to, literally, watch EVERY pub produced by a publisher to make certain they haven't used or re-used or "improperly used" a one-time use license. $1,500 for a magazine use sounds about right IMO.