You pay less up front for the iPhone because the pricing is subsidized through Apple/AT&T. You have to sign up for the 2-year contract which, as has been mentioned, will have to include a $30/month data plan in addition to your normal wireless costs per month. AT&T gets you in and locked into the contract by dangling the iPhone with greater capacity for much less than the same size iPod Touch. That's what they did to me, and I couldn't be happier.

I had a BlackBerry Bold (9000) before this and also was carrying a 16 GB iPod Touch to work every day to listen to music, watch movies, etc. When I found out that a 32GB iPhone would cost less than a 32GB Touch--I had been wanting to upgrade in size for a long time, as I hate having to micromanage my library on a daily basis to add new movies and take off the ones that I've watched, etc.--I bit. I was able to sell both the Bold and Touch on ebay and ended up getting back more than what I paid for the iPhone ($299, on launch day), so it was a win-win all the way around.
In terms of service, that was also a huge upgrade. I used to have people complain about call quality on my end--they were hearing loud bursts of static, that kind of thing, not to mention regular dropped calls. I also had reception problems inside my apartment, but they were somewhat intermittent. Since I switched to the iPhone, no one has said anything about call quality; in fact, it's a little disturbing how well they can hear EVERYTHING that's going on on my end. I was talking to a guy with my bank the other day when I was having problems with my debit card; he had me go into Walgreens, which was my next stop, and check out while he was on the line with me so he could see the transaction go through. While I was waiting in line, he said, "So...Kenny Rogers, huh?" because that's what Walgreens was playing on their in-store sound system, and not loudly at all, yet he heard it very clearly. So apparently now I have to behave myself on the phone and can't sneak a bite of sandwich or something while someone's babblin' away at me anymore.
