There has been some buzz on the forums recently about small sensor technologies.
1) There is the Nokia 808 with 41 MP sensor producing astonishingly good images
2) New Panasonic sensor using a diffraction grid for color separation
Are these and other technologies the death knell of large sensor technologies? In my view, no, yes and even may be.
It is possible to optimize a system. The Nokia has a reasonably large sensor for a phone cam combined with a prime lens from Zeiss optimized for that sensor. It is possible to achieve very good performance with such a combination. The real limitation is that a small sensor does not collect that many photons, which results in more shot noise compared with larger sensors and also reduced DR.
If we look at the panasonic sensor, we have not seen real world results, but the main benefit is probably that it uses all photons available as it doesn't need to loose photons due to filtration. That helps ISO sensivity, but little else.
Now, we have a few different sizes of sensors:
4/3 is pretty good and has a lot of good lenses optimized for the sensor size. 4/3 makes a lot of inroads in old DSLR territory.
APS-C is mature. DSLR lenses are not really optimized for the sensor size, as I see it. There are several mirror less designs, with Fujifilm actually making excellent lenses optimized for the format. Hard to know where the format goes.
Full frame DSLRs have the advantage of size over APS-C, 4/3 and phone cam sensors. Small sensor technology seems to migrate to full frame.
In my view, and limited experience based on APS-C and DSLR I have used, the smaller sensor can deliver, but a larger sensor will always have some advantages. The way I see it a larger sensor collects more photons resulting in smoother highlight and midtones. The larger sensors also make less demand on the lens. It probably takes careful shooting from tripod to fully realize large sensor advantages.
To sum it up: Very good results are possible with really small sensors in optimized systems. To me it seems that smaller formats can be really competitive with larger formats when the smaller format is utilized to it's advantage.
If we go back to film days, medium format was better than 135. At least that was the case in my experience, as long as I shot MF on tripod and didn't need very long depth of field and was shooting with low ISO film.. The Pentax 67 I had needed something like stopping down two extra stops to give the same DoF as my 135 camera. With tripod it was less a problem. What I essentially did was to use 67 with tripod and slow film for careful work and the 135 SLR for handheld shooting, using slow films in both.