A new report claims Xbox 360 will support USB mass storage devices as soon as this spring.
Apparently anything up to 16GB will be usable as the de facto console hard drive.
The report, published by Joystiq, claims to have come from a software engineer at Microsoft. The piece says USB Mass Storage Device Support will be added through a system update.
Any piece of Xbox 360 content - even full game installs - can be done on the USB device, provided it has enough space. You'll still need the disc in the tray to be authenticated for play.