I know a better camera requires thicker hardware
It really doesn't. There are plenty of Sony Erriccson phones with 5mp+ cameras, full autofocus lenses and a flash in much smaller form factors than the iPhone and in just as much space as the iPhone has available thickness wise when you bear in mind the size of their keyboard assemblies.
A much better camera - capable of taking snapshots in dark conditions or worthy of printing out in standard resolutions (6x4' at 300dpi) is prefectly plausible.
Phazer