We assume the narrator is referring to himself. The narrator has had the "milk of paradise." The narrator then points out the all of his observers will "close their eyes 'with holy dread,/ For he on honey-dew hath fed,/ And drunk the milk of Paradise' ” (Enotes). The observers will more than likely tremble in terror and cower before him, the reader can gather. The reader is considered an observer, since he/she is reading the poem; therefore, the narrator is also referring to the reader when he says "observers."
The person who drank "the milk of paradise" is the person who is the subject of the poem: Kubla Khan. The reader should beware because Khan is the great and mighty. The fact that he feasts on honey-dew and the milk of paradise means that he is equal to the gods; think of them as similar to the ambrosia and nectar that Greek gods were said to have dined on. Flashing eyes and flowing hair are often features of gods. "Weaving a circle" three times around him and closing one's eyes are acts of reverence.
Kubla Khan (or Kublai Khan) was a 13th-century ruler of China. Marco Polo wrote that his palace at Shangdu (Xanadu) was exquisite. He was the grandson of Genghis Khan.
This poem cannot be interpreted as anything other than what it is: a dream or vision. Coleridge was reading a different account of the Khan's life before he fell into the drug-induced dream that produced this poem.