I still don't know what it is but as far as the story that is developing it seems like a tablet. Something like the Nokia 770. It could very easily be a small little device just like the Nokia 770. It does make sense for Microsoft to develop such a device, but then again it is just plain speculation and the real device could turn out to be something different.
So far the my next best guess has to be a device similar to Nokia 770 which runs a modified version of Win CE, with Wifi and all the cool stuff you can think of. But then again it could also be a device like the Sony PSP. The reason to come into these markets seems like a good idea. Since they are still not fully developed it makes sense to put your money into these markets. But again this is pure speculation.