From what I've been told, the .7MP photos are fine and even look good on Facebook. it's only when you try to blow them up or print them that you run into issues.
I would think Apple put a camera on the iPod touch for your basic in the moment photos, like a quick picture of a friend or say you walk down the street and see a car accident you can whip out your iPod and take a shot.
Obviously if you're going on a vacation or to a wedding you'd use a separate camera with higher megapixels no?
People are complaining just to complain, and when you tell them why it doesn't have a higher MP camera they flip out and tell you your wrong and say how much they hate Apple and just act ridiculous.
Basically, to shortly explain it, image sensors for still image cameras are a lot larger then image sensors for video cameras and also are generally more expensive. (If anyone doesn't believe me then they can go buy a still camera and a digital and rip them apart only to find out I was right. I had to repair these things for awhile).
For Apple to put in a higher megapixel camera not only would they need much more room (its not just the image sensor that has to go in there, but everything else that drives it) which would take the price up and make the touch thicker. Consumers aren't going to pay as much as it would cost just to have an mp3 player, which is really what an iPod touch is. (Yes I know it does much more but in the eyes of consumers and parents Christmas shopping, its still just an mp3 player with "features".
Obviously Apple isn't going to make fifty different models of one MP3 player and since quality is important to them, they will go with the largest image sensor they can put in in order to keep the price at a good price point and keep the product thin AND have a decent looking camera.
Sure there are 7 megapixel cell phone cameras but megapixels don't mean anything. It all has to do with the size of the photosites. You can have a 500 megapixel camera but if the CCD is the size of a postage stamp the pictures will look terrible. People outside of the photography realm don't understand this and will still cry because its not a 3 or 5 or 10 megapixel camera.
Basically it boils down to people wanting their cake, eating it too, and not paying for it.