They didn't because iPhone is enormously profitable to them. Apple does not want to create their own iPhone killer. The Touch with its nano-sized storage is a niche product only, for those with iPhone envy but no love for AT&T (or myriad other complaints, such as existing cell contracts). With the iPhone reference model, Touch must have been fairly easy to do...very similar hardware, and the rest is software. Geez, there was no reason NOT to do this, from Apple's perspective. This way they get a sale for a product that they wouldn't have gotten otherwise. With the recent iPhone price drop, however, boy doesn't iPhone look more tantalizing than ever? Just $100 more, boys and girls! It should; Apple worked hard to make that happen.
As to iPod classic, yeah, it's fine...if you like watching video on a digital camera preview screen. Never worked for me...but a PSP-sized widescreen with the same massive storage---that's a spicy meatball! But not where Apple's interests lie right now, which is with iPhone. You aren't going to see massive storage in iPhones for *good* reasons; so you aren't going to see it in Touch even if it was a technical slamdunk.