It's not the size of the iPhone screen that could fragment, it's the resolution
Despite case-leaks to the contrary, TiPb heard fairly consistently that we we shouldn't expect a redesigned iPhone this year, and it turns out we heard right. Business Insider, however, is saying that there was a redesigned iPhone on tap but Apple pulled the plug months before.
Steve Jobs was unhappy with the bigger screen because it "fragmented" iPhones, Apple's big argument against Android is the way all the different phones from different manufacturers fragment that operating system.
Which is odd, because screen size doesn't "fragment" phones, iPhone or Android. It's screen resolution that does that. A 3.5-inch iPhone at 960x640 pixels is pretty much the same to develop for as a 4-inch iPhone at 960x640. It's only if that 4-inch iPhone jumps to something like 1280x720 that developers have a problem.
Apple has several prototypes per generation and I'd be shocked if they hadn't and aren't still testing devices with different screen sizes. If Apple does ever choose to pull the trigger on a bigger iPhone screen, they'll no doubt have a plan for it, whether it's slightly reducing the density or boxing the content (like iPad does with iPad apps) to maintain the pixel count.
Even if Apple stays with 3.5-inches, believing it to be ideal for single-handed ease of use, they can't change the resolution arbitrarily without causing massive issues with pixels falling off the grid.
BI's source goes on to say this iPhone prototype had an aluminum back, like the iPad, would eventually use liquid metal in "nano-chromatic" colors, and had a wide, capacitive Home button.
Source: Business Insider