Though just to be clear, his comment makes absolutely no sense, since he was already at that point selling a 3.5" tablet, a quarter of the size of a 7" tablet, with no sandpaper required.
Yes, but they run iPhone apps. Jobs' point was that you wouldn't want to run iPad apps on a 7" screen - if you tried to fit in the extra information you can show on an iPad into a smaller space that would make the touch targets too small.
So now the proposition is that actually you can make an iPad layout fit in a ~8" screen because the iPad touch targets are a bit bigger than an iPhone anyway, and so you can shrink them a bit (to exactly iPhone size, it turns out) and they will work okay. We'll see.