Some rough calculations... WAV files play at 150KB/sec. AC3 or WMP files are 8KB (64Kbps) or sometimes 16KB (128Kbps) per second. Let's say 16KB to be generous.
That is 9.375x compression. A 700MB CD holds 80 minutes of uncompressed music. 1000MB will be about 114 minutes of CD quality music in WAV files. If we factor in the compression of 9.375x we get over 1000 minutes or nearly 18 *hours* of music.
If you cut to 64Kbps you can double that. For use in tiny headphones from a portable player 64Kbps AC3 or WMP is enough.
Conclusion: I don't think more than 1GB is needed in such a tiny player. (Of course in a larger player *with a screen* and a reasonable interface more storage is useful.)