It sounds like a very half hearted attempt.  

http://www.dbtechno.com/gaming/2008/05/06/microsoft-to-battle-ds-psp-with-zune-xna-games/

Microsoft To Battle DS, PSP With Zune XNA Games

Washington (dbTechno) - According to reports, Microsoft is planning to try and join the handheld gaming market very soon. They will try to compete with the likes of the Nintendo DS and Sony PSP with games on the Microsoft Zune.

The Zune games are going to be featuring ad-hoc wireless play for up to 8 players.

The Zune is also going to feature 16MB or RAM for games alone.

Currently, Microsoft has 4 games up and running with the Zune XNA including Zauri, Hexic, and others.

It has also been confirmed though that the device cannot support any type of hardware 3D acceleration.

this could potentially kill the PSP in the west.

Wouldn't these Zune games be in competition more with cell phone based games?

Yeah, the games on this handheld are actual HANDHELD games, not portable console games like on PSP.

My god ... why do they even try ? They will fail misserably lol . No 3D acceleration at all ... WTF ? And why do they try it on the Zune ? Thats one non-popular media player , barely passing the million mark . At least thye could try and make a portable Xbox or something , so the PSP could look even better in comparison :P

@Onimusha : you are being sarcastic ... right ?

Oh, if it succeeds it could steel the PSP's thunder, though that would be assuming the majority of people actually buy PSPs do so to play games in the first place.

I doubt it will succeed, it reeks too much of N-Gage.

Yes, the PSP is shaking in it's boots.

The Zune will kill the PSP. It has HEXIC!!11

It can't produce 3-D graphics. And controls with a directional pad and two buttons. What games can play on that?

PSP = dead confirmed.

So:

-4 games
-A d-pad and 2 buttons
-Less powerful than the DS

This is competing how?

Surely, it can compete with the NES. They have same number of buttons. 

Sounds like a new N-Gage is born. Hopefully it will be more succesfull. Still think it's more of a competition towards something like Ipod and mobile phones and not versus the handhelds.