How far are we away from miniaturizing the iPhone so that it can be worn as a watch, allowing for cuts in certain features? What would make it worth buying and what would we cut? Well let's see, I imagine it would...
At least one FaceTime camera
Considerable disk space
Perhaps even music playback, if space is such a premium
Of course any exclusions would be for intro models, since as time goes on all could theoretically be included.
Like the Apple TV, it should have some undocumented internal flash storage to make FaceTime stream better and download text messages and such.
The crucial commercial roadblock about this device is that all message input would be through voice. Texting is by far our most popular way to communicate on mobile devices. We're at a stage where voice recognition is pretty good, perhaps even commercially viable for this sort of thing, But of course it would only be a transitional feature. This device would phase out the popularity of texting in favor of rapid FaceTime exchanges.
Texting has the advantage of privacy, but I don't see why we can't make advances in whisper voice recognition. Siri will not recognize my whisper at all. But there would always be the regular old iPhone.
Just as the iPod nano is a lighter fun device, just so the iPhone nano would be.