The best use of physics will be the ones that achieve both a visual improvement, as well as have an affect on gameplay. The super exciting thing that has come out of GDC are people's impressions of Ubisoft's Project Assassin. The kind of movement and IK based systems that they are making sounds really impressive and I think that'll go a long way towards making the game look great, as well as having a substantial impact on the gameplay.

I'll give an example of what I'm talking about.
Scene: A sword fight versus two Knights
1 - Eye Candy
The enemy is wearing chain-mail armour that shakes, and hangs realistically. When the sword strikes the armour the chains deform inwards and react to the strike.

2 - Gameplay
Being able to throw your sword at the enemy. Or picking up a box and throwing it at the enemy. Or cutting the ropes of the bridge your enemy is standing on so he falls to his death.

3 - Gameplay & Eye-candy
You both swing at the same time and your swords hit one another, based on the momentum of the swords, how strong you are, the NPC is etc, you and the NPC get your swords knocked backwards, and the NPC gets staggered a little. If you're stronger then you're able to regain your balance quicker and go in for the kill (with the angle/power/speed of the slash again being dependent on where the sword was and how strong you are etc).

I think 3 is the thing I want to see the most out of next-gen. Though the funny thing is that both scenarios 2 and 3 can be achieved entirely without physics, it just won't look as natural. So then maybe it's all eye-candy. Personally, I see gameplay physics as a way to decrease the amount of work required to achieve a compelling experience.