Microsoft have confirmed that in the 6th April Xbox 360 update, support for USB Memory will be added. This update will allow profiles, game saves, demos and more to be saved on a USB Memory Stick.
This update allows 2 USB Memory Sticks, from 1GB to 16GB, to be used. you can choose to setup a USB memory stick with the Xbox 360 by plugging 1 in and heading to the Memory section. from the storage devices list, you will be able to configure a USB Stick to be used with the 360. you will be able to choose how much of the stick can be used exclusively for the 360.
Flash Memory sticks are recommended over HDD based ones and people are advised to remove any files from the USB before setting it up for use on the 360 as the 360 will erase all files on it.
Screenshots
From Major Nelson
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