Apple builds more products than it releases. It's entirely possible (if not probable) that Apple developed a 7" prototype. Just like I'm sure there's been a CDMA iPhone prototype. That means nothing however. Just because there is/was a prototype doesn't mean there will be a product.
I believe the 7" competitors come down to two things:
1. The competitors might feel like they need to differentiate themselves from the iPad; or, more likely,
2. Apple has tied up the world supply of 10" capacitative touch screens so the competitors needed to go for parts they could get.
Unfortunately a lot of these Apple rumours are started and propagated by people who simply don't understand how Apple operates or are simply link-baiting.
In this earnings call, Jobs basically ranted about how it isn't Open vs Closed that is important. This is probably aimed at solidifying the competition's commitment to an Open system and making them less likely to switch to Closed and "admit Apple was right", when the "Closed" nature of Apple's devices is a critical competitive advantage of the Apple platform.