Apple is already shrinking the screen size on the iPhone down from 3.5 inches to 3.2 inches, which is not that severe of a drop. It is just enough to allow the device to cut down on battery life a little, and to make it thinner. It is rumored that there will also be a miniature version of the iPhone, that will sport a 2.8 inch screen, which is almost an inch smaller than the screen on the current iteration of the iPhone.
There are advantages and disadvantages. One advantage is that less screen to illuminate is obviously going to draw less power. This could help make up for the extra juice that the 3G chip and the GPS chip will suck up. This shot is a side by side comparison of the device sizes, which shows it will look the same as the current iPhone. Just think smaller with more features.
One negative thing about this photo, there is no hole in the face plate for a front facing camera. If this is the real deal it shatters the dreams of iPhone video conferencing. One thing that would not be so great about the smaller screen is that means a smaller interface, and smaller on screen keyboard. This could prove to be a big problem for iPhone users if the interface proves to be too tiny.