The highly reliable Apple rumorist, John Gruber of Daring Fireball said on The Talk Show that Apple is working on a 7.85-inch iPad, which will have same resolution as iPad 2. He said the following about the 7-inch iPad:

I do know that they have one in the lab. A 7.85-inch iPad that runs 1024 x 768, it just like the 9.7-inch iPad shrunk down a little bit. The apps wouldn’t need to be recompiled or redesigned to work optimally on it, it’s just that the iPad is smaller.

I didn’t believe at first, but I have heard this before and I have done little screenshot testing on the iPad. One way to get a feel about how big it is, is to take a screenshot on the iPad holding it in portrait and then rotate it to horizontal, to landscape and show that same screenshot and that how big the interface will be. The height of the 7.85-inch iPad will be same as the width of the current iPad. And its usable, there are couple of areas where text is little small, but it’s not ridiculously small.

And I have heard from numerous people that, that’s one of the ideas that they’re noodling with. I have no idea and I have heard from nobody that it has any kind of time frame for when they ship it or if it’s something they want to ship. I think it’s something, it like a maybe.

John talked more about why or why not Apple will ship the 7.85-inch iPad. You can listen to The Talk Show on 5by5 website. John starts talking about the 7.85-inch iPad after 1:16 mark.