Retina was Apple's "screen size upgrade" for the forseeable future. The devices like the Sensation and SGS II have screen resolutions of 800x480; 480x320 just wasn't going to look good next to them. Apple's stuck at 3.5" like you mentioned, so to compete with the new high-resolution (and larger screen, as a result) devices, they doubled the iPhone 4's resolution, which is a pretty decent compromise. One of the benefits of increasing resolution without increasing the display size is that your DPI skyrockets, and they jumped on that and marketed the crap out of it. The display looks "better", even if it's not larger. I would be genuinely surprised if Apple released an iPhone variant at >3.5". They might release an iPod Touch around ~3.75", but that's as high as they can really go before the 3:2 aspect ratio starts to make the device width prohibitive.
In order to maintain "Retina" display, they'd need to keep their 300 pixels per square inch or more density. That also doesn't leave them a whole lot of room to bump up the screen size without bumping up the resolution again. They've got some small room to play with in terms of the screen bezel though, so we could see a screen size bump without a resolution bump that still offered both the 300 ppi and the ability to touch all of the screen with one hand. (Think about some of the "iPhone 5" leaked images). Time will tell.
They can maintain that "retina" claim as long as the marketing department gets away with it. I think they can easily get away with that down to 200 pixels per inch or so (anecdata: I am myopic, but cannot really see the individual pixels on an iPad 1 Or current iPod touch)
I guess that the extra wiring needed for retina resolution means that you need more backlight to get the same display brightness. If so, one way to market a slightly larger display with say 250 pixels per inch would be by stressing it as having better battery life ('easier to see for the elderly' would work, too, but such a line does not fit Apple's image well)
