iPod Touch to sink iPhone in Europe?

Is it me or has Apple lessened the reason to buy an iPhone, with the launch of its new iPod Touch? The new gadget has the same touchscreen system as the iPhone, has wi-fi and also has more memory for music.
Tomorrow, we'll find out about Apple's plans for its "UK" iPhone launch. O2 is expected to be the operator unveiled as the "UK" partner. Surely it'll feel a little miffed that half the iPhone's functionality is now available to the wide world on the new iPod? Why bother signing an expensive contract with O2?