I have no doubt that Apple tests all sorts of shapes and sizes for potential new products. That doesn't mean that any of them stand a chance of production. In their labs there probably are iPads from 5" up to 15" in different aspect ratios etc. That's part of R&D, and a company like Apple invests heavily in R&D.
The only way this thing is for real is if the current iPod Touch is getting killed off. Additional space would make for more battery room, and more room for storage. They've wanted to kill off the iPod Classic for a while now, if they can get more storage into a Touch, they may be able to pull it off.
Beyond that, the iPod Touch is a popular gaming device. Especially for kids and teens who's parents aren't ready to bite the bullet on a phone with a monthly data plan.
Increasing the size and capacity of the iPod Touch could be a smart move. Even if a 7.85" iPad is coming, that device would still be too big to slip into a pocket and from the sound of things, wouldn't have a Retina display. The iPad Mini being rumored really just sounds like a cheap iPad. A 5" iPod Touch with Retina could easily be presented as a premium product to replace a cannibalized one.
That may also indicate that the iPhone will continue to have a 3.5" display, which while some may complain, is a major differentiator between it and the other Gigantophones on the market currently.