Once the update occurs, Xbox 360 owners will be able to download Xbox Live Arcade games, Xbox Live Indie games, Games on Demand, DLC and Title Updates to the storage device. "USB storage devices may, however, have far greater memory capacity than MUs (at the date of writing, the largest MU is 512 MB), and may therefore support previously infeasible operations-such as installation of a full disc-based title." That's right, you can also store disc-based games to the USB device; however, it will require the disc to be in the tray for authentication, identical to the current functionality.
According to the document, the USB mass storage device must be at least 1GB and the system will do a compatibility check. "The system partition occupies 512 MB of space, and by default the consumer partition occupies the remainder of the device capacity, or 16 GB, whichever is smaller." Upon inserting a blank USB storage device, "consumers are offered two choices: 'Configure now' or 'Customize'." The "Configure now" option will use "the entire device capacity, up to the maximum of 512 MB plus 16 GB" meaning, regardless of the overall size of the device you're using, the Xbox will only enable 16 GB of usable, non-system storage. The "Customize" option will allow you to "preserve some pre-existing, non-console data on the device" such as music.
It should be clear by now that Microsoft is simply pulling out of the Memory Unit business and not the highly lucrative Xbox hard drive business. With an artificial cap of 16 GB – still shy of the 20 GB hard drive that shipped with the original 2005 Xbox Pro and a fraction the size of the currently shipping 120 GB hard drive – USB storage support simply removes the onerous requirement for a Memory Unit on Xbox 360 Arcade units, and brings the Xbox 360 platform a feature that's been present on the PlayStation 3 since that console's 2006 launch.
If you're intent on circumventing Microsoft's cutthroat hard drive pricing the Xbox 360, you can use two USB storage devices for a maximum of 32 GB of usable storage; however, the console "has a fixed limit of two external USB mass storage devices" regardless of whether they're "formatted for the Xbox 360 or not." If you fill all three USB ports on the console, only the first two to be connected will be recognized.
With talk of a new (slim?) form factor for the Xbox 360 picking up, and plans to abandon (or at least obviate) Memory Units underway, we're guessing those Memory Unit slots could be cut entirely from future iterations of the console.
Update: We asked console modder extraordinaire Benjamin Heckendorn to take a peek at the rumored motherboard and this post, and we've gathered his thoughts here.