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The camera, in all its VGA resolution glory. The camera itself is less than 3 mm thick.
Space may have been a factor in not including a better camera. Excluding its mount, the camera in the iPhone 3G is about 6 mm thick. The 5th Gen nano is 6.2 mm thick at its thickest point.
Unlike the nano, the touch, at 8.5 mm thick, could conceivably support an iPhone-sized camera, although it would certainly be an engineering challenge.