I call shenanigans. When current iPhones are $199 and $299 I don't think Apple will feel the need to make a cheaper model when people are paying more than that to get an iPod Touch. I wouldn't want to see a smaller iPhone anyway, I like it's screen size the way it is.
I don't feel there is a market for an iPhone nano. Not unless it drops much of the functionality of the iPhone. As I am sure most developers are aware, the production of apps that rely on touch is highly sensitive to the size that a human finger contacts the screen. A screen of any smaller size would probably render most of the touch applications useless, and severly limit the potential of future touch applications for such a small device.