Every console fills a niche (spot or occupation) in the gaming world.
Think back to last gen, when the PS2 filled the "variety console" niche. The Gamecube never had a chance. In order to be successful, the Gamecube should have taken the variety console niche, but it couldn't because the PS2 already had that position, and nothing could knock it out of that spot.
Then came the XBOX. Which, like the Gamecube, was only marginally successful, stopped dead in its tracks by the PS2. This was the food chain of the last generation of consoles, with the PS2 occupying the "all-in-one" gaming niche that made it the ideal choice for both developers and gamers.

This generation, things are different. The Wii has fleshed out its very own niche: the casual niche, and NOTHING will unseat it. It has no competition. Congrats to Nintendo! The "variety console" niche is still being occupied by the PS2, thanks to incredible planning by Sony.
So that leaves the other gaming niche, the "hardcore" niche.
The 360 filled this spot with alarming speed, but for some reason it did not dig in. Microsoft made several big mistakes that kept the 360 from wholly occupying the hardcore niche (you already know what they are), and that is why MS should be scared about what is happening now. The PS3 is gaining momentum on the 360 at such an alarming rate that the 360's position is quickly becoming harder and harder to defend. With Sony planning to keep PS3 support for ten years, you have to stop and wonder, what will happen when the PS3 eventually unseats the 360? The prospects don't look good.

When Microsoft releases their next console,  they may find themselves between a rock and a hard place. Both the PS3 and the Wii will have the gaming niches completely filled, and any console Microsoft releases will be successful under only one condition: it creates a new niche for itself to fill.
They could create a new niche in the way that the Wii did, by creating a radical new control interface or some new way to play games that consumers will find irresistible.

If MS does dump 360 support withing the next couple years, 360 owners might have to buy a new console, while the PS3 fans will still be enjoying theirs. The new console would not get a lot of gaming support, because everyone would be developing for the PS3 and Wii.
Don't worry, because as I said there is a flip side. If MS successfully creates their own niche, then things will get very interesting, but in a good way! They will not have to worry about competition, because they will have the niche all their own.
Looking at current MS trends, it is easy to see where Microsoft is making mistakes. They have copied the Mii's from Nintendo, have several drafts for a Wii-mote like controller, and still charge for XBOX Live, despite having no rational justification to do so. By copying the Wii they are attempting to invade Nintendo's niche, and there is absolutely no way the Wii will be beaten. By charging for Live, Microsoft shows that they view a gamer as nothing more than a tool. If Sony and Nintendo also feel this way about gamers, then they hide it very well.

Anyway, lets wrap this up....
For the time being, the 360 is a decent piece of gaming hardware taht is both satisfying and well received. As time goes on, expect this to change drastically. As Blu-ray becomes the new game-storage standard, and developers are able to fully utilize the power of the cell,  the PS3's massive life cycle is brought to a reality, and Microsoft will need to make some big decisions. If it makes the wrong ones, it will no longer remain a competitor in the gaming arena.

Sony and Nintendo are no fools to the market, they invented it.