Now you folks know I harbor no love for Apple, but the iPod success is good for everyone (except Microsoft). It's raised the visibility (and sales) of Apple computers, particularly notebooks. More Apple computers means more non-Internet Explorer browsers on the Internet, which means fewer sites using Windows specific patented technologies, which means OS/2, Linux and even Amiga users will be able to enjoy the Internet on into the future.
At this point dropping Internet Explorer support for Apple computers is exposed as a strategic blunder on Microsoft's part - and they thought at the time it would marginalize Apple users.
Microsoft is hamstrung by Windows, an unwieldly, insecure, bizarrly complex and fragile structure based on antique code, obsolete methods and always on the verge of total collapse. I'm sure they've never completely understood how it works.
Bill Gates made very clear how irrevocably bound Microsoft is to this beast when his people enthused over Java in a meeting. His angry statement, "Has anyone here ever heard of Windows?" effectively ended any possibility of breaking free.
So yes, they should be very much afraid. Far from the World Domination they expected NT/IE to bring, they are now in a defensive position, under attack from multiple forces with more flexible and rapidly strengthening weapons. Defensive positions always lose in the long run.
I wouldn't be surprised if Microsoft issued a total ban on iPods, but it would serve only to increase the company's insularity and misjudgement of the world at large.