It's a Kindle Fire competitor. Without doubt. Having played with one at one of the IO Extended events today, and given the massive emphasis on the play store and video/audio/written content being made available Google are definitely making a play for Kindle territory here.
Like you, I'm pretty ambivalent on the 7" format, but that isn't stopping people from buying Kindle Fires...
I'm a Kindle Fire and an iPad owner, and I love my Fire.
It's large enough to read on comfortably, and about the weight of a similarly sized high quality book, meaning that it is light enough to handle for a long time without trouble. It carries by hand very easily, and just doesn't get in my way.
The iPad (v3, btw), in contrast, is bulky and heavy to carry around and hold. The keyboard still isn't big enough to touch type on comfortably, and I am not able to produce content on it with a reasonable speed (after 1mo of use, I gave it to my wife). When I need to create, I usually ended up using my notebook computer, due to the size limitations and difficulty of using the keyboard while holding the device anyways.
In the end, the Fire is the perfect size for portable media consumption, and the addition of an unlocked (and high quality) operating system makes this new offering by Google a no brainer for me.
Like you, I'm pretty ambivalent on the 7" format, but that isn't stopping people from buying Kindle Fires...