Maybe because pretty much everyone that would use an mp3 player already has one, and making them a little smaller isn't enough of an upgrade for someone to buy a new one. Plus, most new phones play mp3s, so why bother carrying two things around when you can carry one? Smaller is not innovative when it can simply be imbedded into something you already carry.
If I was Apple I wouldn't be throwing much more money into new mp3 players. All these fast phones with G3 connections...When the subscriptions services finally incorporate properly into phones it will be a whole new deal. I'd love to have napster on my htc.