The update will significantly improve Kinect's performance; the device currently has a resolution limit of 320x240, but the rumored update would increase this to 640x480. Furthermore, the update could also increase the amount of data that the sensor can transfer, from 15 or 16MB per second to 35MB per second. The end result would be a much more precise device: it would be able to recognize things like the rotation of the user's hand or even individual fingers.
Kinect's current data limitations are in place so that the Xbox 360 can support multiple USB devices at one time. Microsoft is working on improving the technology to get around this restriction but it's not yet clear if the software giant will be able to pull it off. In any case, we won't know for sure until the company confirms the rumor, which likely won't happen until they achieve the feat and are reasonably happy with the results. If it really is in the works, the firmware update would arrive in the spring of next year, though developers would probably get to work with it sooner.