I'm very surprised at those saying, "get a real camera" to take video. My sister was planning to get an iPad and she has two small children. I know she may often surf the internet on the iPad, and the kids may do something she wants to capture on video and that's why the iPad would be an ideal USER FRIENDLY (just like the iPhone is) video camera for in-home use. I understand it may look silly to use it in public, but I don't imagine that's where most people would use it. 1 megapixel would not illicit a very nice picture, and I would be disappointed if I though this rumor was true, but I just don't believe it is

.
Just to clarify, even the current back camera on the iPod Touch can collect 720p VIDEO, which is just fine, even if played back on a large TV. The 1 MP camera would take very poor (by modern standards) still PICTURES. So in the scenario you describe above, it would do just fine. If she wanted to take portraits for the family Christmas card it wouldn't do very well.
Some possible uses for the back camera, sorted by my best guess for frequency
[more common]
1) FaceTime show them what I'm seeing (video)
2) Virtual Reality, overlay info on top of live feed (video)
[less common]
Take some quick video of what is around you (video)
Take some quick pics of what is around you
For both of what I see as the most common uses, a 720p video input with descent framerate and passible lens would be fine. As it would for quick spur of the moment video. It would be be worse than almost any cell phone from the last five or more years to take still pictures with and so would be a real problem for users who wanted to use it to take high quality pics who didn't have a recent cell phone that they could pull out to use instead.
Which is to say, while better is better, for most (but NOT all) use cases I can think of, this would be usable as long as the lens was decent quality.
I could see someone (not me, but someone) setup the iPad as a HUGE viewfinder on a tripod, using software to apply filters, effects, and cropping 'live' while viewing the screen as a closer to final size view. For that user, the 1 MP camera would be a big fail where the iPhone 4's 5 MP camera and its wonderful lens/software quality would be much better however, if I was doing that kind of stuff I'd be looking to use a real camera to do it with, not an iPad, even if it had a 5 MP camera.