I think this would be a very appealing product for a certain segment of the market - not everybody has tens of gigs of music you know. In fact, I'd wager that MOST people (at least, aged 35+, an especially women) posses less than 100 albums, of which only a few will have been ripped to their computers.
A 4GB limit is no barrier to people like that - they aren't looking to put their music in it anyway, and even if they did you can fit most of 100 almbums on to 4GB. But what they want is to get all the cool iPhone benefits like GPS maps, email, Safari, the App Store, games, etc...
At $99 you'd better hope that they're making plenty of these things.
The reason the 4GB didn't sell well at first was that the early adopters were precisely those people who do have loads of digital music and photos and movies. It was also too expensive to be a value proposition - but at $99 it's a no-brainer.