Anyone who thinks you can't do a differentiated multitouch 7" UI is either lying or incompetent. Steve is clearly not the latter. My prediction is that within the next 18 months they release a 7" iPad. Sooner if a 7" Android tablet takes off.
Neither works. Neither is compelling. UI design is fundamentally different between a 4" screen and a 10" screen, regardless of the actual screen resolution.
The only reason people are talking about 7" tablets because Android 2.2 is absolutely ridiculous on a 10" screen (see previous paragraph). It's also a way for these manufacturers to compete on price with the iPad.
The concern isn't that Apple couldn't make a variant of iOS run well on a 7" tablet: it's that the product itself doesn't really have a purpose for being, and that it's asking too much for app makers to target (well) three different sizes that are so close to each other.
(Now, is the current iPad too heavy? Yes. I strongly expect the next iPad revision to be 9.7" and 1/3rd lighter.)
The problem today is that I have a phone that is really too small to be super useful. I've made considerable concessions, but really browsing and apps on the iPhone kind of suck. It's just they suck a LOT less than phone apps used to. And given the relative infrequency for which I talk on the phone, why do I want to have the phone drive the size of this device?
At about 7" I have an adequate mobile experience, and I can stop using my phone for things it really isn't very good at.
With that said, I'll take a 10" tablet at .75 pounds, which folds in half to the width of something like the Samsung Galaxy tab today (and of course, unfolded there is no visible seam).
Because I'm having a hard time seeing what tasks would be notably better on a half-ipad-sized screen. Reading would be better than a phone, sure. Videos, sure. But beyond that, I'm not sure what the draw is.
It seems any task beyond those two (consumption, the very thing people dismissed the ipad as only being good for) would suffer from the lack of significantly increased tap real-estate.
I mean, even the keyboard itself would have to be annoying. In portrait, it'd be little-better than a phone and in landscape it's the same width as the ipad's portrait keyboard, which is just not good. (far too narrow to touch-type, but too wide to thumb-type)
And I can't say I'd be optimistic about Android app developers notably filling the gap at the outset. Even if they can figure out how to add capability in that space, with the array of screen sizes on their way, I wouldn't want to gamble on how much attention they'll be spending on any one screen size. Not until there's some shake-out and consolidation.
I recall that you had and disliked an iPad. It just seems odd to me that you'd dismiss the iPad as not being useful enough, yet jump on the bandwagon for a device that is inherently less-useful.
It'll be smaller and lighter. But still large enough that it's not going in your pocket. So what's the draw?
 and that's coming from a fairly large-handed fellow; I found the original xbox "duke" controller to be the most comfortable gamepad I'd ever held.
So actually it is two devices I've used: The Archos Home Tablet 7 and the Samsung Galaxy Tab. The Samsung was way better. The Archos has a resistive display which makes it hard to navigate and a REALLY slow processor. But in terms of button size and general UI layout, both do a good job.
For me the big app draws are those you listed, videos, reading ebooks, but also general web navigation and maps.
The keyboard on the Galaxy is better than the iPad keyboard. In part due to the size. The same reason I prefer portrait sliders over landscape sliders for phones.
My use for a tablet is almost all consumption. This is in part why I think the 7" form factor is so great. I don't pretend this is a laptop replacement.
And the Galaxy tab fit into the pocket on my jeans, admittedly I have them really loose and they have pretty big pockets. But it will also fit comfortable in an inside jacket pocket or a purse.
But the price needs to come down. Even if I prefer a 7" form factor, I'm not going to pay the same price as a 10" form factor. I'll just feel cheated. But I expect we'll see good 7" Android tablets for $299 in the next six months -- if the Tab comes down to that price, I'd get it.
I find the size far more convenient than larger devices. I'd much rather have a generic prepaid phone and a kindle-sized pad than an iPhone and a 10" iPad.
There's plenty of room for a roughly 7" tablet of some sort to enter the market.