Haven't read the whole thread (I know, bad me).
OP, I completely understand where you are coming from. I was coming from the same place until we got a free IPod Touch for signing up for Comcast. I would never have spent the money for one for a child that young (way more than we spend for gifts for a child that young). But our five year old absolutely LOVES to play with it. Would I run right out and buy one for her knowing what I know now...just maybe.
I have a ton of educational apps on there. She's learned a LOT about math at a more advanced level than she would normally be taught. It's not frustrating for her because it's a game. She also started sounding out words to lay the groundwork for her reading skills. Finally, there are some just plain fun ones on there.
As far as music, we have some fun classical music (Nutcracker, Sleeping Beauty Waltz, etc). We have lots of instrumental Disney music, some Barney

, and a lot of children's church music. She listens to the music almost as much as she plays the games.
It's also so portable that when we travel she can watch a movie using headphones on a plane. Lots of DVD's come with a free digital copy so we've got Toy Story and one other movie. We have the 8 GB so it doesn't hold much in the way of video.
It's fun because we have lots of kid shows in our instant streaming with Netflix. When we are watching a more grown up movie (not

grown up, but something like Pirates of the Caribbean) she can watch something on Netflix in the same room.
Finally (again, bad me) we love to take it when we go out for dinner at a sit down restaurant (or at the two hour dinners on
DCL). She wolfs down her little kids portion of something and if we want to enjoy a leisurely meal and dessert, she can just play the IPod for 20 minutes without being bored. In the past, we've brought a few playmobil people, some coloring materials, or something to read. The IPod can just go right in my purse.
We really love it!