Windows 7 may harken back to the days of Windows 95, when you could choose what applications you wanted to install with Windows.
But with a twist, as charging users different amounts for the various modules will be more widespread, and it opens up the possibilities of adding subscription based software modules as well, such as anti-virus.
When Windows 7 launches sometime after the start of 2010, the desktop OS will be Microsoft's most "modular" yet. Having never really been comfortable with the idea of a single, monolithic desktop OS offering, Microsoft has offered multiple desktop OSes in the marketplace ever since the days of Windows NT 3.1, with completely different code bases until they were unified in Windows 2000. Unification isn't necessarily a good thing, however; Windows Vista is a sprawling, complex OS.
A modular Windows 7 is a lock
The first reason Foley gives is that Windows Server 2008 has "server roles" which can automagically determine which packages are installed and how the system in configured (more here). Foley suggests that this approach on the server side would translate well to the client, but the process of modularization has already begun on the client side.
Windows Vista was designed so that all three consumer editions—Basic, Premium, and Ultimate—can be installed off of one DVD and can be upgraded in place from one version to another. The changes can be "deep," since (for instance) Home to Premium can enable Aero Glass, and Premium to Ultimate can add BitLocker drive encryption, etc. My point is that Microsoft is already selling a "modular" OS, and the modules currently map to Windows Vista SKUs. Microsoft is also developing other modules around its Live efforts.
Unsurprisingly, Microsoft already has a patent on a "modular operating system" concept. A "core function" module, which includes the kernel, features a "license validation module" that authorizes the use of all additional modules, and uses DRM-like technology to prevent the use of unauthorized modules. Windows Vista uses part of its anti-piracy arsenal to validate and monitor changes to the OS for this reason.
So, Windows 7 will be modular, but to an unknown degree. I personally expect the modularization to focus on value-adds, as did Anytime Upgrade on Vista. It allows Microsoft to draw lines between what is and isn't "in" the OS for DoJ compliance issues. Whether it be Live Services, Windows Media Player, or even Internet Explorer, Microsoft could roll those into modules and then say, "Hey, look, that's not part of Windows, we're charging extra for that!" Foley says that she's heard from sources that Microsoft is working on a Photo + Mail + Video module that would exist apart from the OS, for instance. I've heard less specific groupings myself.