There are (generally) two approaches to physics simulations in games/movies: Kinematic and Dynamic.
In the last generation (PS2/XBox/Gamecube/Dreamcast) developers were finally able to do Dynamic physics engines; which essentially means that last generation it became possible not to script a lot of physical interactions between objects. The PS3 and XBox 360 can have a ton of objects that are being simulated physically. There are few games where this actually impacts.
AI hasn't improved from processing power in a long time ... It is a problem which has just had greater resources thrown at it. What you're going to see on PS3/XBox 360 titles is the exact same scripted AI that existed on the PS2/XBox except it will have more scripted events and more "intelligent" characters on screen at the same time.
