I can't decide if Apple is going to come out with a 7" tablet or not. There's definitely a place for something that fits into a labcoat but offers a lot more screen real estate than a phone.
On the con side, there's also something to be said for concentrating one's efforts on just a few offerings.
I disagree that Apple are going to come out with a 7" iPad in the short or even medium term. Years from now? Who knows?
I think the divide with form factors is: does it fit in your pocket? 3-4" phone? Yes. 10"? No. 7"? Still no.
I believe there are so many more use cases for 10" that Apple didn't just pick that number out of a hat. For example, I own a Sony Reader (6"). Great for reading novels. Terrible for technical books (and, by extension, textbooks).
I can hold my iPad on one hand. Thing is though, I don't. I really don't know what the use case is for holding it one handed. It's always sitting on a table or desk, on my lap or on my chest (if lying down).
The problem that Apple faces here is one of fragmentation. The UI on the 9.7" iPad isn't just going to scale down to a 7" without any problems -- look at the difference between using the portrait and landscape keyboards, and now imagine that kind of difference in physical scale applied to everything else in the UI.
So, that means they'll have to retool the iOS UI conventions once again. Which means a third target. Universal apps will now have to have usable interfaces on iPhones, big iPads, and small iPads. It seems like a lot of effort to support something bridging a relatively small gap, and I don't think Apple is going to see that as necessary until the tablet market has matured a lot more.
I don't really agree on scaling down the UI. After all, the iPad's 10" UI is almost identical to the 3.5" iPhone's. I see no issues with using a 5x4 (or even 6x4) grid of icons on a 7" model. Also if the iPhone can manage a keyboard, a 7" tablet surely can too.
That all being said, I still don't believe Apple is planning a 7" model.
It's not just the home screen/keyboard UIs, though, it's the UI of the apps themselves. Many iPhone apps written for a 4" screen don't feel at all right on a 10" iPad screen (though admittedly some do without much tweaking, like the home screen), so lots of apps would need to come in iPhone/Big iPad/Little iPad versions. Of course, at some point, developers don't care enough to tune for each and every size, so you might end up with a decrease in general app quality.
On that note, it'll be interesting to see how Android deals with this. There's certainly a place for 7" tablets... and for 15" tablets, too.
I've recently acquired a... satchel? Man bag? Okay, it's basically a purse. My iPad is slightly too big to fit inside comfortably. A 7" tablet would probably be the perfect size for that.
If we assume that most people want the largest screen that they can comfortably carry around with them, there are a lot of people who could fit 7" in a purse-like sack, but can't fit the 10" iPad.
I'm also skeptical of the idea of an iPad with a 7" screen, mainly because typing on such a screen would be far worse than on the current one.
However, such a thing would probably be a lot more pocketable than you'd think. My Kindle 2 (9" diagonal and 3/8" thick overall) fits very nicely into all of my inside coat pockets.
The Kindle 2 also weighs less than half of what the iPad does, which is important; I thought about having a giant pocket sewn in to some of my jackets, but then I realized that I'd need a counterweight on the other side, and I actually got as far as starting the weight-and-balance calculations before concluding that this was getting silly. The counterweight idea would require keeping the jacket buttoned all the time, anyway.
A high-density-screen iPad the size of the Kindle 2 would be worse for movies, photos, and (especially) typing, but I could have it with me nearly everywhere, not just places where I am willing to carry my nerd bag.
I don't think it's an if, it's a how and a when. The advantages of a tablet that's easily held in one hand are just too many, and if they wait, the various Android devices are going to noticeably eat their lunch.
I'm sure that Apple has had numerous sizes brewing in R&D since the beginning; the big obstacle is how they'll deal with the software platform. Will devs have three form factors to target when developing iOS, or will a 6-8" iPad have the exact same ratio and resolution as the old one so that everything "just works"?
On the con side, there's also something to be said for concentrating one's efforts on just a few offerings.