The most interesting mock-up of the 'project Cafe' controller I've seen is one where It's a wiimote, with a six inch touch screen down it's length, that clips into a Classic Controller Pro shell.
That to me seems like the most reasonable and probably. As it's still a Wiimote (with touch screen) the casuals will identify with it and love it's simplicity still, while 'core' gamers will clip it into it's shell and play traditional games, in the traditional style. Since all users will have a CCP now, 3rd parties can easily port all games onto Cafe, greatly increasing it's librarys over Wii's.
Meanwhile Nintendo can continue with it's Wii___ series of games which just make use of the wiimote/touch screen aspects.
Re: The OP. Overall sounds assumptions. As I wrote elsewhere, I don't think Cafe is going to start a new arms race. Sony/MS do not need to launch new systems to compete with a system that's playing the exact same games. Sony's 1st/2nd party exclusives and move are sufficient to keep it competitive (especially if it's cheaper than Cafe!). MS will need to moneyhat some exclusives or really do some exciting stuff with Kinect or it will have a hard time competing with two comparable systems both which have far more popular exclusives.
