100% Digital distribution is going to happen.
Oh I'm sure you'll still be able to pick up copies at Wal-Mart or Target if you really, really want to, at least until the business model completely falls out from under physical distribution. But ultimately physical copies will more or less go away (Caveat: You might be able to go to a Kiosk in the mall and download a game copy to your own media, I can see being a good business model to service customers with poor broadband or usage caps).
I can tell you exactly how this will happen:
1) Companies like Microsoft, Sony and Valve will offer incentives to publishers to sell DLC through their platforms to familiarize the customer base done.
2) Digital Distributors will include anti-piracy methods into their platforms to make digital distribution more attractive to publishers. done.
3) Prices on downloaded games will become cheaper than physical copies to entice customers done
4) Publishers will realize that selling part of the game on-line will make reselling used games less attractive for brick and mortar stores (and capture those consumer dollars - see: Electronic Arts). done.
5) Publishers will ink "exclusive deals" with digital distributors to make games down-loadable before they can be bought in stores (Not sure if this has happened yet?)
6) Some genius at Microsoft or Sony will realize that if they publish and distribute on their own network a triple-a title, they'll make more money than releasing it multi-platform and with physical distribution. First "download only" triple-a game arrives.
7) All digital distributors who aren't currently publishers become so, financing game development for distribution on their networks, potentially as a new publishing house (shell company).
8) First cross distribution contract is signed for multi-platform games from one of these new publishing companies.
9) Sky-net becomes self aware.
Okay, maybe that sounds a little conspiracy-theory-ish, but the truth facts are a lot of that stuff has happened already, a lot of it is just plain economic sense, and I'm positive that as soon as the figures line up in the correct order, the rest of it will happen.
Also, I think people are going to shit themselves when Microsoft releases the XBox VM. Just wait for it - maybe not this next console generation, possibly the one after it, but Microsoft is going to turn the XBox into a virtual machine, you'll be able to purchase a stand alone console, a virtual machine to run on your windows PC, or remote net access through Windows Azure. Hell, RemoteFX is so good right now I'd be surprised if the geniuses up in Redmond weren't already demoing the technology.