This rumor simply won't go away but when two reputable news organizations pick it up, we should sit and take notice. Bloomberg and the WSJ are both reporting that Apple is working on a 7.85 inch (Sharp IGZO screen) iPad mini that will retail between $250 - $299.
Google's Nexus tablet will try to break Apple's stronghold on the tablet market by offering an extremely well equipped consumption tablet (made to consume not create content) for less than $300. Analysts saw this as a competitor to the Amazon Kindle Fire but many new would be tablet buyers may be swayed by the competitive price and nice featureset. However if Apple does enter this market with a small, low price point, then Google's uphill battle just became a little more difficult.
We know how much Steve Jobs hated the 7-8" tablets so it remains to be seen if the new leadership at Apple is willing to make such a radical departure from the Jobs standard. Having played with the Kindle fire and the Blackberry Playbook, I like the small form factor but you have to be willing to give up some comfort and functionality.