I disagree. In fact , in 2007 a 3.5" screen was considered HUGE for a mobile phone. Maybe they couldn't have done it larger because of Battery life issues.
...and certainly also for marketing issues. There were already bigger screens on the market then - but on on phones, remember iPaq and similar HP or Palm devises. Apples concept was (I guess) to have a product that was less PDA and more phone.