Is it OK to review a paper which builds on my work?

You were probably chosen to be reviewer because it is built on your work and therefore have intensive background knowledge on this topic. As long as you have not worked and do not intend to work on something really similar during the review process you do not have a conflict of interest.

You should of course try to be objective. Giving a rejection does not have to discourage the authors if you give constructive feedback and make it clear that you find their direction promising.

If you feel like you might not be able to be unbiased you can talk to the editor about it.

As others have said, the editor very likely knows the situation. Review the paper -- you are well-suited to do so. If you feel compelled to mention it, do it in the "confidential to editor" area to maintain the anonymity of the review.

That said, if you've never been in this situation before, be very careful to make your review fair. Lose any hidden agenda. Review the work the author is submitting, and not the work you wish the author had done. Limit your context to information that is available in your field, and not bring up stuff that your favorite colleague is about to include in an abstract for next years Big Conference. If the data presented make a previous paper you've published look a bit questionable, that doesn't make the manuscript bad.

I advise bringing this to the attention of the editor. Let them know that the paper they have asked you to review cites your own publications and that the potential conflict of interest exists. Whether you ultimately accept or reject the paper there could be the appearance that you were not an impartial reviewer - acceptance could be seen as being influenced by the citations and rejection could be seen as being influenced by competition in your field.

It could be that your field is relatively small and the editor has passed the paper to you as a subject matter expert.