I doubt we are going to see the external design change much. I is already iconic, and there is not much that can be changed. Can't make the screen bigger. Don't want to make the screen any smaller. Could shave it down a little thinner - but better to use any "free" space that more compact components may allow to boost battery life.
Perhaps another camera could be added to the front for video calls - but that never caught on here because the cell companies got greedy and wanted to charge way too much for it (like they did with data before T-mobile offered half decent rates - and the iPhone crowbared open O2s offerings). Apple may actually make the idea take off at last.
An interesting think I noted in the specs for the chips around which the iPhone is built is that the maximum resolution camera supported was - you guessed it - 2Mpixels. Which is just what we've got. That chip also had lots of video handling capabilities - so the existing phone could be upgraded in software to capture video (direct to uTube posting application anyone).
From a hardware point of view I don't see the iPhone changing that much for the next two versions. Figure a constant upgrade of the memory as density goes up. 3G version to expand into other markets. Everything else will probably be software updates.
Around 2010 Apple may be ready for a more substantial redesign.
Where things get interesting is if they go the iPod route and do an iPhone Nano. Personally I think a reduced size/reduced feature set device sacrifices too much. How they could do an iPhone Shuffle is a question for which I'm not sure I was to see the answer.
Will I replace my iPhone with the next version? That depends on a lot of things...
1. How much will it cost? I could see Apple introducing an update with an 8 and 16GB version, with the 8GB being less expensive - offering 8Gb for £249 and the 16Gb for £299 would be the kind of price points Apple would need to hit.
2. Contract terms for existing iPhone customers. This would need to be made very clear i.e. buy an iPhone v2 and just activate it. No extra contract time. No extra charges.
3. How much better G3 is. I've been on the road with my iPhone at the start of this week. Gave the thing a real field test - which is passed with flying colours I may add. Perhaps I was lucky - I have Edge here, and the locations I visited also had Edge and/or Cloud WiFi connectivity. G3 would not have delivered a significantly better experience. Perhaps a few things would have been a little faster, but would I have noticed that much? Bottom line - I liked the iPhone when I got it. After that trip I like it even more because having it was very very useful. Google Maps got me where I was going. Mail and Safari kept me in contact. The music and audio books I ripped onto it kept me entertained. I even made a couple of phone calls.
4. Screen quality

I have a perfect screen. Not something I'd give up lightly - and you just know Apple will be trying to source screens that keep production costs down and margins (especially if the price is cranked down any) up.