Major Nelson (aka Larry Hryb) has confirmed that Microsoft is slated to release a system update on April 6th which will allow the Xbox 360 to use USB flash drives for storing game saves, demos and other content.
"Once you take the system update on April 6th, you'll be able to connect your USB flash drives to your console and head over to the memory section to configure your new storage device," Nelson explained on in an official blog post.
"Once you do that, the system will conduct a one time performance and integrity check to confirm the drive is working properly. You will then be able to configure how much storage to use on the device, up to 16 GB. The remaining space on the flash drive will be accessible by your PC or Mac."
However, Nelson acknowledged Xbox 360 owners would only be able to use up to 16GB of space.
"Since performance on flash based USB storage is usually better, I highly recommend using flash based instead of spinning media like a hard drive...It's just going to give you a MUCH better experience."
Nelson also noted that MS had "enhanced" memory management functions by offering users improved control over content copied or moved between various storage devices.
"You can have 2 devices connected to the console at a time, enabling up to 32GB of simultaneous storage. [And], The system won't just configure the device once it is connected to the console.
"You'll need to head to the memory area in system settings, select your USB Device, and choose from Configure Now (Format and Configure the Full Device), or Customize - you can choose how much memory you want configured for Xbox360 from the free space on the device."
Finally, Nelson announced that Microsoft would be partnering with SanDisk to release an Xbox 360 branded USB flash drive in May, which will will arrive "pre-configured" out of the box and "ready to go."