Anyone that doesn't want a bigger screen, even if the phone overall retains the same size and shape, is an idiot.
A bigger screen makes routine tasks much more pleasant, browsing the web, reading ebooks, watching videos, playing games, everything looks much nicer on a bigger screen.
I worked some mock-ups in my cad program and a 4" screen will fit (in the iPhone, without making it bigger):
If Apple cuts down on the amount of room the bezel takes, the screen could be made 4 inches without making the phone any bigger.
It would be like having to choose between two otherwise identical tvs, both with the exact same size and shape, with the only difference being that one is 13" with a really thick bezel, and the other is 17" with a slimmer bezel, and opting to go with the 13" inch version with the thick bezel. There is no rational reason why someone wouldn't atleast want a 4" screen if the phone remains roughly the same size and shape.
Unless you actually like looking at a black bezel and want the bezel to be as thick as humanly posible.
Hell, here's a picture of the iPhone retaining the same height while housing a whopping 4.5" screen...
With all the new media apps coming this yr and into next, it's ridiculous to watch all that on a 3.5 inch screen no matter how high the resolution. I'm a media guy and would much rather watch all that hi-res on a 4.whatever screen rather than a 3.5. At least sell two phones. One for the soon to be minority 3.5ers, and one for the rest of us. Why waste all that valuable iPhone space on those black bars on the side of the screen?
Take a look at this picture, comparing the iPhone to the HD2 which offers a 4.3" screen, and yet manages to be approximately the same size and weight as the iPhone, while offering superior battery life!
Ignore the OS on the HTC HD2 and just compare the screen size between it (4.3") and the iPhone (3.5").
The pic also depicts the subtle difference in size. Not much at all.
"From my experience, it's far easier to use the on screen keyboard, browse online, read pdfs, emails and e-books, and watch movies with an extra inch of diagonal real estate. Everything just looks nicer, especially games, websites read easier when the text isn't quite so tiny, and movies feel more immersive. It's shocking how big a difference that extra inch makes." -iPhonedHome
Apple could continue to sell/manufacture the 2010 iPhone 4 for $99 for people who want that, and manufacture a 4 inch screen alongside it priced at $199 or $299 for everyone else.