Apple is going to have to play this one carefully. They don't want to cannibalize their iPods sales, but clearly there is a substantial (and cheaper) Flash player market that needs to be addressed. And it will only grow.
Yes, today's solid state memory may only hover around one gig, but that won't last. It will keep climbing as we all know. Even at one gig, that's what, a few hundred songs? That is plenty for any typical need. No, it's not good to archive your whole library, but it's sure enough to get you through a workout, a long drive, or weeks of general listening. And for anyone not convinced, just look at the iPod mini. Clearly there is a huge audience of people who don't feel the need to put every song they own on their iPod. (Or the audience doesn't have a lot of songs. Either way, the point remains the same.)
Speaking of working out, that's where the current iPods just don't cut it. There is a substantial market for (myself included) people that want a more durable "iPod". Presumably a Flash player would be just that.
Now the price point is always the sticking point with Apple. They need to build them and price them to have perceived quality and value. Apple customers don't just want a "flash player", they want the best flash player. Apple can get away with selling them at somewhat of a premium, just like they do for everything else they sell. Effectively, they will concede the low end market to the multitude of other sources.
In summary, I think a flash ipod makes total sense and would fill a market demand which exists that Apple does not have a product for.