There is some pretty credible evidence out there now Apple is working on a lower end iPhone model for 2009. True or not I'm willing to speculate:
Just as the Shuffle isn't really an iPod in any classic sense I would expect any lower end iPhone model to not really be an iPhone in any classic sense. (no touchscreen, no app store, no wifi etc)
There's no practical way to cut the current cost of the iPhone 3G by $100. Reducing storage only saves you maybe $20. Reducing the size of the touchscreen makes a touch keyboard impossible and breaks existing apps. You simply couldn't use most app store apps on a screen even 70% as big as the current iPhone. (too small, not enough DPI for accurate input) Downgrading to EDGE saves you almost nothing. Downgrading the processor power is pointless. (breaks third party apps) So there is basically no way in hell Apple can reduce the current price of the iPhone in any significant way without producing a product that no one would want anyway.
So based on all that I would bet the iPhone Nano would be just what it says. A Nano with a phone built in. No bells & whistles. The UI would be engineering to have an iPhone look & feel but the device would probably continue to run either the classic iPod OS (vxworks I think?) or perhaps it would be the first iPod using Darwin but it would retain the simplicity of the iPod line and any connection to full blown iPhone/Touch OS would be purely cosmetic.
So why would Apple do it? Simple.. To offer an iPod AT&T can give away to people for free with a contract. (or a minimal fee) Apple got into the phone business knowing that phones would completely replace stand alone MP3 players someday. This is just the next logical step. They can ensure the iPod and iTunes Store stay relevant in a post-PMP, cell-centric world. It's interesting to note the new Nano is easily the most cell-phone looking iPod Apple has ever sold. It actually looks more like a cell phone than the iPhone does. Just add a mic & speaker, update the software, and you're all set. As long as Apple does 3 core things well it will satisfy a huge market:
1) Play music & video as well as existing iPod models (check)
2) Make phone calls as well as existing iPhones with a similar UI experience (pretty easy to pull off, check)
3) Be something you can walk out of an AT&T store with for $49 or $99 depending on storage. (check)
As an extra cost cutting measure I would expect there to be no requirement for a data plan.