Joystiq has is reporting, and has confirmed, that a future 2010 update for the Xbox 360 will allow USB storage.  This will be more than just the ability to read music, movies and photos of the USB drive. From Joystiq's story;

Once the update occurs, Xbox 360 owners will be able to download Xbox Live Arcade games, Xbox Live Indie games, Games on Demand, DLC and Title Updates to the storage device. "USB storage devices may, however, have far greater memory capacity than MUs (at the date of writing, the largest MU is 512 MB), and may therefore support previously infeasible operations-such as installation of a full disc-based title." That's right, you can also store disc-based games to the USB device; however, it will require the disc to be in the tray for authentication, identical to the current functionality.

While this sounds like a replacement of sorts for the current hard drive (thoughts of a 500GB USB drive did dance in my head) there is a catch.  No matter the size of the storage device, it will be capped at 16 GB.  You will be able to plug in 2 USB mass storage devices both 16GB giving you a total of 32GB.

While that might seem small I see some good things I can do with that.  Move all my songs for Guitar Hero and Rock Band off the hard drive on to a couple USB memory sticks would be nice.