In a blog post, Microsoft's Larry Hyrb (aka Major Nelson) said the update will let users utilize as much as 16GB of a flash drive for game-related data, and up to two storage devices can be connected at once for a maximum capacity of 32GB. USB hard drives "may work" but you'll still be limited to 16GB of storage. The remaining space will be accessible with a computer.
After connecting the device, you'll have to head over to the memory section and configure it. You can perform a full format, or choose how much memory you want configured for the Xbox 360. Once that's done, the system will conduct a onetime performance and integrity check to ensure the drive is working properly.
Microsoft notes that while any flash drive can be used, it is partnering with SanDisk to release an Xbox 360-branded USB flash drive in May, which will come pre-configured. No price was given, but hopefully it's not as expensive as other Xbox 360 storage products.