Wall Street Journal:
Apple, which works with suppliers to test new designs all the time, could opt not to proceed with the device.
That's really the only important part of the article. Of course Apple is testing tablets with smaller screens. Just as Apple is certainly constantly testing phones of 3 or 4 different sizes. It's unlikely anyone in the industry tests as thoroughly as Apple does. Testing doesn't necessarily indicate intent to bring to market. Anyone who proposes without real inside knowledge (which no one outside of Apple's upper management has) that Apple will introduce one soon would--if Apple did so--be right only by coincidence rather than by insight.
Having multiple sizes of the same device always brings a cost--especially for iOS. Android, like Mac OS X and Windows, is not made for fixed resolutions so new screen sizes and resolution scan easily be thrown around within reason. iOS, however, only runs at 3 resolutions to date, one of which is exactly quadruple another--allowing for design elements to stay exactly the same physical size. iOS only has two target UI sizes right now. The trade-off between the two approaches is simple: design consistency and sharpness (iOS) versus display size flexibility (others). Introducing a new larger phone or smaller tablet will mean current apps will have comparatively poor usability (Apps designed for a 9.7" iPad will end up having extremely small touch targets on an 8" or 7" tablet--or apps designed for an iPhone will just be less clear than what people are used to and have oddly large touch elements), so if optimized apps are possible to make at all it will introduce yet another design target.
These issues aren't necessarily insurmountable. If Apple introduces more physical sizes for its touch screen devices, it will be because it decided the usability / interface fragmentation sacrifice is less significant than the gains provided by a new size OR they've figured out a way around the problem. Anything is possible, so Apple certainly could introduce a new size touch device, but simply testing sizes is not evidence at all.
(For the record: I think a scaled up iPod Touch at 7" would probably be more usable than a scaled down iPad, but I can't exactly test such a thing. Even then, it would certainly be awkward for many iPod Touch / iPhone apps and definitely not optimal for the size.)