The story came from Daring fireballs john Gruber. While speaking on a podcast Gruber stated that he had heard there was a prototype of the 7.85 inch model floating around the Apple campus. An article on the subject in The Verge quoted him as saying:
runs at the same 1024 x 768 resolution as the iPad 1 and 2. Such a device wouldn’t quite match the clarity of the new iPad’s Retina display, but at around 163 pixels per inch would still offer a sharpness increase over the original iPad without apps needing to be rewritten or updated.
To be honest I personally can’t see Apple bringing tis to market since the already control the tablet market with one market size there isn’t really much need for the to add variety to the product line. It may just lead to confusion with customers not knowing which tablet size to purchase. However Apple did bring out different size models in the iPod and that seemed to go down pretty well so I guess like all other thing Apple we shall wait and see.
src: The Verge