For smaller iPod's like the Shuffle, iTunes has for a long time had an option to convert audio to lower quality to fit more on the device. But for some reason this feature was not available on the iPhone until recently.
As I accumulate more music, and at higher quality, and therefore larger files, my iPhone has been getting full, despite being a 32gb model. I have a few apps that take up more space, like Wikipedia and CoPilot Live but the majority of the space is audio.
Recently I noticed that this option had appeared for my iPhone. I think it probably came in the last update, but it may have been there for a while and I just missed it. It freed up over 10gb of space on my phone! Very nice. Audiophiles will no doubt disapprove, but in the places where I listen to music on my iPhone, I doubt I'll notice the difference.
NOTE: Because this requires updating all the music files on your phone, the next sync after setting this will take a while. Don't do it when you're short of time.