If we look at the original comments as quoted as hearsay, I'm not sure there's been enough analysis of what this rumor really means.
As Chef Medeski points out, there's really no reason to increase the size of the device just to increase the resolution of the screen. There are plenty of screens of higher resolution than the paltry 480x320 screen on the iPhone. So when this German dude says that the new Atom-based "iPhone" "needs" to be larger because of the "resolution" of the screen, that to me suggests that either the screen is at least 800x480 (at 4" to 4.5" diagonal) or even greater (1024x600 at 4.8" to 5.5" diagonal). These resolutions would be overkill on just a phone -- only a few Windows Mobile devices have a full VGA screen. However, 800x480 would be minimum for a MID, from the standpoint that the "standard" website is 800 pixels across. Increasing the resolution beyond this point is helpful for UMPCs but comes at a cost of readability/size and power consumption. So the only reason the proposed device "needs" to be bigger is because it is designed around a larger screen and/or a larger battery.
Furthermore, the Atom is not intended for phones or PDAs, but for MIDs and UMPCs. It has a broad range of speeds (I think 800MHz to 1.6GHz). While the power consumption is higher than the CPUs in cell phones/PDAs, it is much lower than any other mobile processor Intel has produced. The benefit to a company like Apple is that the Atom CPU will run the same code as any of their other CPUs. Since the iPhone runs a version of OSX, switching over to the Atom makes sense.
So the Atom is slightly physically larger, and it also draws more power, meaning you need a larger battery. This proposed device also has a larger or higher resolution screen, which also uses more power. At that point, you are looking at a larger device that is 3G enabled. But it's not a phone, in the sense that current iPhone owners are happy, but would be happier if the phone were just a little larger. This thing is a 3G enabled MID. It's not a UMPC. The whole distinction between MIDs and UMPCs doesn't apply anyway, since the iPhone is already running on OSX. But if you call it a UMPC, what you have is a small, low-powered, more expensive notebook, with at most a tiny keyboard if any at all. It sets up the expectation that it will run "the same" OS, but with a processor that will set you back about 5 years technologically.
If you take a look at the soon to be released (in Asia) Sharp Willcom D4, you'll see that any form factor is possible but limited by battery life and usability issues. The D4 is a UMPC/phone running Windows Vista on a 1.33GHz Atom CPU, 1GB RAM, and a 40GB HDD. It has a largish phone w/ flip out keyboard design with a 5" 1024x600 screen, and it claims a 4.5 to 5 hour battery life. It is 3G enabled, and apparently has special software to use the device as a phone from within Vista.
http://www.geekstuff4u.com/product_info.php?manufacturers_id=&products_id=742
I would suggest that the limiting factor for size in these small devices is battery life. A MacBook has a 4h battery life, but for some reason, the smaller the device is, the longer we want the battery to last. Nobody thinks a 3G enabled MID that has 4h of battery life is particularly desirable, because we want it to last all day.
Further comments:
1. There's no way this is an e-book reader with an e-ink display. It might be something you can use as an e-book reader, but you don't need an Atom CPU to display text, and e-ink technology is still not ready for full adoption.
2. Text on a 5" 1024x600 screen would be ridiculously small. At a certain point, if you want a higher res display, you need to make it larger for usability purposes.
3. This German dude probably didn't really know what he was talking about.
4. It won't be "reasonably priced." It will be expensive.
5. I hope it's a tablet at least 8.9" diagonal with more than one button and one USB port.
6. If it's a MID, it won't also be a phone. I.e., You'll need both. (!)
The HTC Diamond has a ppi at about twice the iPhone, but a smaller screen. At 3.5" you could easily get that resolution with less ppi. Thats a touch device too unless multi-touch needs much smaller resolution (which it doesn't seem to have). So its certainly plausible that the iPhone could have a 720x480 with the same form factor. I imagine 1.5x each dimension would be a bit too big. But about 1.25x with a screen size of about 4 or 4.5" and a smaller border, would be pretty good size. It would look a bit large, but nothing too ridiculous and would greatly help looking at website and videos.
Hopefully they add a MicroSD or SD slot so we can easily upgrade 8 or 16GB up.
I wouldn't mind using it as a phone.
The HTC Diamond has over twice the ppi of the iPhone, so I'm sure it wouldn't need to be that big.
tv or to show a presentation to a client. A bridge between macbook air and the iphone. If a tablet is really a tablet the screen should be big enough (5x8 or other sizes) to display rich content. 
