There have long been rumors of a smaller iPad. However, some time ago on an Apple earnings call CEO Steve Jobs went on a tirade against 7" tablets (aimed primarily we assume at the Galaxy Tab). Here's what he said at the time:
First, it appears to be just a handful of credible entrants, not exactly an avalanche. Second, almost all of them use seven-inch screens as compared to iPad's near 10-inch screen . . . [The] screens on the seven-inch tablets are a bit smaller than the bottom half of the iPad display.
[E]very tablet user is also a smartphone user. No tablet can compete with the mobility of a smartphone, its ease of fitting into your pocket or purse, its unobtrusiveness when used in a crowd. Given that all tablet users will already have a smartphone in their pockets, giving up precious display area to fit a tablet in our pockets is clearly the wrong tradeoff. The seven-inch tablets are tweeners, too big to compete with a smartphone and too small to compete with an iPad.
Despite this apparent public rejection of the 7" format, Apple was and is working on a smaller (more portable) version of the iPad. According to iLounge:
While Apple apparently decided to scuttle the 7” version of the iPad it was working on last year, our source notes that a key iPad, iPhone, and iPod component provider has been asked by Apple to develop a part for use in a seven-inch iPad. Our source believes that this part is for a new version of the device that is still in development, and doesn’t know whether it will go into production. The request suggests, however, that Apple is continuing to keep the idea of a smaller-screened iPad alive despite having pooh-poohed competing 7”-screened devices as “tweeners.”
While this rumor must be cautiously received it makes sense. The smaller form factor is responsible almost entirely for the reported success of the Galaxy Tab (2 million sold, 16% returned). The high return rate further confirms the appeal of the form factor. The device is mediocre but people are drawn to it because of the smaller size.