Moto Droid has a 24MB limit on all apps. This is indeed hurting game development. It is said the Nexus One allows up to 32MB per app, but I am not sure if that is Nexus One or Android 2.1 that permits that. Even so, the iPhone allows only 32MB of ram per app as well, and they manage to squeeze very good high end games onto it, so it's possible. Heck, it wasn't too long ago when 32MB ram was a ton of memory.
The bigger problem for Android is the lack of a JIT for the JVM, and hardware access to the audio and video buffers from within the NDK (their native layer that you can use to write C code to speed things up). Several developers have done performance comparisons, and slower devices with J2ME run 10 to 20x faster than Android on the G1. That's REALLY sad. For most of the end users, Android is plenty responsive/fast enough, but that J2ME with its severe limitations is a lot faster is really bad. There is however a JIT in the works, so every android device (that can upgrade to whatever release it comes in) will see a nice "free" performance boost.
The hardware access is a real killer tho. Music apps like BeatMaker and others on iPhone simply aren't even possible on Android until we get low level hardware access. Latency is a big issue as well. Even tho we developers can write multi-touch apps, the latency from the time the screen is touched to actually playing a sound can be down right dismal. There are apps that play quite well. The good news is, Open CL is in the works, the same audio api that iPhone uses. So hopefully we'll see that sooner than later and more music apps, as well as better game audio/music can be put to use. As for the graphics, I think the big issue here is that like audio, there isn't direct access to the video subsystem from within the NDK (native layer). A lot of the more high-end games are going to be written mostly in C. The native layer currently has limited, if any access to the video frame/buffers so everything has to be passed back up thru to the Java layer and it's slow.
In comparison, the moto droid and nexus one are much more powerful than the iphone 3gs, yet the games you see now are basic games on iPhone. The high framerate responsive games on iPhone simply aren't possible just yet. But to be fair, Android has a lot more going for it, with every carrier, handset maker, many companies, etc behind it.. it's going to take longer to develop completely so that everyone involved gets a fair shake at it. I suspect by end of 2010 we should see some sort of major update that will greatly enhance the game/music development potential for Android. I am hoping anyway. We will need it if we want to be competitive. With the iPhone 4G and it's dual core cpu, dual camera, 2x memory, and so forth coming soon, we're going to need some ammunition to fight the good fight.