if you have a cage like that, you should return it if at all possible - it's WAY too tiny for a bunny!
actually, ALL store-bought cages are too tiny for bunnies. bunnies should have a nice, roomy cage (and because they don't have an exercise wheel like most "cage" pets, they need either 4-5h a day of "out of the cage" time to roam the house (once you've bunny-proofed!) *or* 60+ square feet of space that they have 24/7 access to).
a LOT of people build a NIC/C&C style cage (the size you should have depends on just how much time your bunny spends out of it each day, but I wouldn't go smaller than either 4 grids long x 2 grids wide x 2 grids tall with a partial second level or 3 grids long x 2-3 grids wide x 3 grids tall with a second and maybe even third level. personally, I went with 3x2x5 (three levels) and then fenced in my living room with playpens so that my bunnies have 24/7 access to a 120+ square foot "run" space... but then, my girls are quite spoiled
(shows how to do coroplast floors if you'd rather use that than plywood)
best deal on grids for the cages (assuming you're in the US): http://www.sears.com/stor-floor-stan...1&blockType=G1
here's my condo:
a decent alternative to a NIC condo is to use one or more x-pens (exercise pens) to create a living space for your bunny. if you're stuck with the tiny store-bought cage you already have, I HIGHLY recommend that you get a playpen and zip-tie it to the front of the cage so that the bunny has access to the pen while "caged" (you may need to put something on top of the cage to make it taller so that the bunny can't get on top of the cage to escape).
is the best deal I know of for a playpen up to 30'' tall - it's $35 with free shipping. if you follow the link and browse the "customer images" for the pen, you can see a lot of great examples of people using it to create a living space for their bunny.
if you want something taller than 30'' (because your bunny is a jumper or because you want to be able to put cardboard boxes and such inside without fear of the bunny getting on top of something to jump out of the pen) then I recommend this playpen - http://www.petco.com/Shop/Product.aspx?sku=31313
- in either the 36'' or the 48'' version. personally, I went with the 48'' since it was only a few bucks more and gave me the most options as far as furnishing their enclosure.
anyway... as far as your actual question goes, I wouldn't use any sort of bedding at all in the cage because that makes it harder to litter box train them (tends to confuse them into thinking the whole cage is a potty).
the most popular type of litter seems to be wood stove pellets that don't say they have an accelerant added (available from hardware stores in areas that have cold winters) or wood pellets (available from feed/tack stores) - they're really good at odor control and either one will run you around $5-8 for a 40 lb bag, making it the cheapest litter you can buy.