Since they've come so far down in price, and the Kindle 3 is a pretty significant upgrade, I chose the latter option. I gave the K1 to my other roommate, the K2 to my SO and ordered the K3 with 3G for myself. I went with the "graphite" version because I thought the dark case would be easier on the eyes in bright sunlight.
The Kindle 3 is slightly smaller than the previous generation. They've managed to shave about 1/2 inch off the sides and drop about 2 ounces. The screen is still the same size as the two previous models. The back cover has a slightly rubbery feel to it; it feels better than the aluminum back the K2 used. It's now available in two colors, white or black.
The Kindle 3 has a greatly improved e-ink screen. Refresh rates are much faster and the contrast has been improved significantly. The previous Kindles had a sort of light-grayish screen with dark-gray ink, but the K3 has a very slightly-grayish screen with almost black ink. It's very easy on the eyes and I feel no strain at all, even after spending several hours reading. Pictures, while still grayscale, really stand out. Like the previous models, the screen is perfectly readable even in full summer sun.
The original Kindle 1 and the early Kindle 2s had Sprint 3G radios, which worked almost flawlessly here (in fact, the reason I switched to Sprint for my cellphone is because I got such a good signal). The Kindle 3, alas, has an AT&T radio, which doesn't work worth beans here. On the rare occasion that I've managed to pick up a signal, it's slow-ass EDGE, not 3G. Fortunately the Kindle 3 also has WiFi, so I can still get my newspaper and magazines wirelessly at home. In Omaha, I get a decent 3G signal most places I've tried it. As with past versions, cellular service is free for the life of the device. Amazon also offers a WiFi-only version of the Kindle 3 for just $139.
The power switch, volume buttons and ports have been moved back to the bottom of the device. I think I like this arrangement better than the scattered approach used by the K2. The page turning buttons are smaller on the K3, and there is now a previous page button on both sides of the Kindle. The Home, Menu and Back buttons are no longer along the side and have been moved to the keyboard, making it less likely to hit them by mistake. The tricky "joystick" from the K2 has been replaced by a D-pad which sits lower and is harder to accidentally bump. The keyboard seems more responsive than the previous versions. I am rather disappointed that they removed the number keys from the keyboard; now you have to press the Sym key and use the D-pad to select any numerals.
The Kindle 3 has a microphone on the bottom, but there isn't any software on the device to actually make use of it; the user guide claims it's for "future use". The K3 has stereo speakers on the back, just like the K2, though the built-in MP3 player still blows (but really, it's a book, not a iPod. I wouldn't expect an MP3 player to have a decent book reader either.)
Like the K2, the K3 doesn't come with a cover, you have to buy it separately, and they're not cheap. The top end Amazon-branded cover costs $60, about 1/3 as much as the Kindle 3G itself! On the plus side, it now comes with a built-in book light that is powered off the Kindle and shuts off automatically when the Kindle goes to sleep. It's also available in 7 colors. (They also offer a non-lighted leather cover for $35, and there are third party covers and cases for as little as $20.)
There are lots of other minor improvements and tweaks. Storage has been bumped from 2 GB to 4 (supposedly about 3500 books). The web browser is now based on WebKit. You can choose from 3 different fonts to read (Caecila, Caecila Condensed. and a san serif font). Battery life has been improved, supposedly up to one month with wireless turned off (I got 3 days of very heavy use, about 3-5 hours a day reading mostly newspapers and magazines). Amazon has announced a future upgrade will allow Kindle users to lend books to other users.
Three generations of Kindle
Comparison of the thickness of the various models
Size comparison between the Kindle 2 and 3
The new lighted cover at work.