There are all kinds of kinky things going on in Orthodox bedrooms (see Calm Kallahs and the Frumsex messageboards for proof) but no one is having sex through a hole in the sheet.
Talit Katan: not lingerie

This rumor seems to have come from people looking at Orthodox Jews and their hardcore commitment to modesty and assuming that even during sex they’d insist on keeping everything covered up. But in fact, according to halacha you’re not allowed to have sex wearing any clothes at all, or anything that serves as a barrier between you and your partner (condoms are out).

Specifically, the hole-in-the-sheet things may have come from people seeing Jews in religious neighborhoods hanging their "talitot katan" out to dry. This poncho-like garment is about two feet by four feet, has a fringe on each corner, and a hole in the center for the wearer's head, and it looks somewhat like a small sheet with a hole. So, if you have a dirty mind, you might look at it and assume it’s some kind of uber-modest lingerie. But it’s not.

Actually, the rabbis have a pretty laissez fair attitude about what we do in bed, with the basic rule being that ejaculation has to happen inside the vagina (though some rabbis are even lenient about that).

Check out Snopes, and WorldNetDaily for more on this myth.

Previously: Blood Libel