I think it should be fine... the diff between a payg and a contract sim is the info they have on their system... so if someone tells them to do a transfer, it should just be a matter of inputing into the system which sim his contract is now working from, and the reason the ipad sims won't work in an iphone is cuz they only have a data plan... no calling or sms or anything... it's JUST data... that's why an iphone sim will work in an ipad... so if he tells them to put his iphone data on that micro sim, it should work.
I said I THINK it should be fine cuz all that is just what I understand from the whole thing... and even if it's all technically possible, O2 might not allow some things...