The Verge user modilwar has a nice write-up on their forums about how Apple could make a 4″ iPhone without compromising the Retina display, the layout, etc.
I usually try not to comment on rumors, because they tend to fly in your face down the road, but it seems that John Gruber all but confirms it:
Methinks “Colin” wasn’t merely guessing or idly speculating.
John Gruber has an impeccable track-record on predicting Apple’s direction, so you may want to read the article by “modilwar” at the link above.
This is also the first piece on this subject that does make sense to me.