Dustin Curtis provides his reasoning as to why Apple sticks with a 3.5” screen:

Touching the upper right corner of the screen on the Galaxy S II using one hand, with its 4.27-inch screen, while you’re walking down the street looking at Google Maps, is extremely difficult and frustrating. I pulled out my iPhone 4 to do a quick test, and it turns out that when you hold the iPhone in your left hand and articulate your thumb, you can reach almost exactly to the other side of the screen. This means it’s easy to touch any area of the screen while holding the phone in one hand, with your thumb. It is almost impossible to do this on the Galaxy S II.

Makes sense to me. Apple doesn’t compete on a feature list, they compete on experience.