The iPod nano has proven to be extremely successful for Apple and has helped contribute to the iPod's current dominance of the portable media player market, but whether or not the company will apply that same logic to the iPhone has been a source of debate for quite a while. Recently, rumors of Apple preparing a low-profile iPhone have surfaced again, in part due to an apparently leaked iPhone XSKN Case.
The case, if real, is clearly aimed at an iPhone considerably smaller than the one available today. The device appears to give up some of its screen real estate in order to accomplish the tinier size, and since Apple is silent on the subject this is nothing more than speculation at the moment. There's a lot of incentive for Apple to produce a tinier device - the release of RIM's recent Blackberry Storm shows that other manufacturers are taking notice of the iPhone and want to directly compete with it, and feature-for-feature modern smartphones are differing less with each generation.
Apple's not as ahead of the game in phone technology as they are in mp3 player technology, so this is an obvious route for them to take. Whether or not this is real remains to be seen.