The big problem with a smaller iPhone is the App Store issues. Sure, I suppose they could increase the number of pixels per inch. But that doesn't help at all, when your finger isn't shrinking by the same amount. As a developer, we're advised to have a minimum hit area for all buttons and interface items. Making the device smaller would shrink those areas as well, making it hard to use. Now, I can believe these rumors if the Nano came with a pointing device, so you could activate the new tiny controls...