I have heard from a guy "in the know" that it may be possible that the PS3 will not be 100% compatible with PS2 and PS1 games....does anyone know anything about this? I think it would be extremely bizzare (not to mention stupid) if this were the case.
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It will not be hardware downwards compatible, only software. I prefer this method, as it means firmwares will still be released to increase compability, which isn't the case if its only hardware downwards compatible. Though at the beginning the firmware may still not run as much games as with the hardware method.
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There will always be some compatibility issues between different hardware. Look at the compatibility between different computers of the past. The Atari STFM and the STE and the Amiga A500 and A1200. Both upgrading systems had some compatibility issues with software originally written for the older system. This is always due to games coders taking full advantage of system hardware right down to the basic core level, coding directly to the memory registers of each chip in the system, so that when a new improved system is released the memory registers will be different and may cause issues and compatibility problems.

As for the PS3, yes there are some compatibility issues, but as Demon said, Sony did the wise thing and adding the compatibility into the firmware of the PS3 so as problems with specific games are found they can be fixed and released in the next firmware update. Sony have already been doing this and already released a firmware update that fixed the compatibility with many PS2 and PS1 games.

There is an online database of PS3 compatibility here It is in Japanese so might be hard to navigate easily but it does contain information about PS3 compatibility with each of the complete 7,841 games in the Sony PS1 and PS2 database!

UPDATE: I also found the US compatibility status page now here which gives very detailed information about the compatibility of each game you search for, saying exactly what the issues currently are.

BTW, did you know that the PS3 actually contains the PS2 CPU and GPU processors to aid in better compatibility of older PS2 games? Much as the PS2 contains the original PS1's CPU for better compatibility with PS1 games. This combined with the firmware configuration settings for PS2 compatibility, each time games are found to contain some compatibility issues they can be fixed by Sony.

And most of the compatibility issues do not mean a game will not run at all. A lot of the issues are things like missing audio in menu screens or background music in game. Such things are annoying by the games are playable. There are not that many games that will not run at all.

This is in stark contrast to the Xbox 360 where backwards compatibility with the older Xbox games requires direct compatibility code for each game to run, and so only the games that have code written to run on the 360 will work, which is not many out of the complete Xbox back catalogue.
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The thing is that they removed the actual PS2 Emotion Engine chip from the european model. It is present in the Japanese and US models and provides stable backwards compatibility. It isn't included in the Euro model, but is emulated in software instead. Take this with a grain of salt, but I heard from someone on a different message board that no model was supposed to have the chip in it, it was supposed to be software emulated all the time. The launch models got the chip in it because the software solution wasn't ready. It still isn't, so not including it in the European model means backwards compatibility is going to be poor at least to begin with.

But as was said, continuous updates of the firmware is going to keep improving the compatibility as time goes by. But it won't be that great in the beginning, sadly. PS1 emulation however is promised to be just as good as it was on the PS2. Whoever said that was going to be bad is just plain wrong.

The european backwards compatibility list is going to be here, but it isn't going to be available until the 23rd.
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I didn't know that had removed the Emotion Engine chip from the European version of the PS3. Maybe this is why the release date is really so much later than the other region releases? After all they would need to do some motherboard redesigning. The removal of the chip will definitely reduce manufacturing costs for Sony and hopefully help bring down the cost of the console soon.

But as you say, removal of the chip will definitely reduce compatibility to begin with, but once the firmware starts to be updated it should be just as good as any hardware solution.

I just thought. If this is completely in the firmware they must be emulating the PS2 pretty well in software. If some emulation hackers can get hold of the firmware and disassemble it they might be able to reverse engine a pretty good PC PS2 emulator. Just an idea.
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Fair enough, the dude I talked to didnt go into much detail about it, but if it has firmware updates it should be ok.
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This is what most of the websites seem to be saying. A lot of people are pretty angry about it from what I have seen. A lot of people really are hoping that the PS3 screws Sony. Personally, I don't really care one way or the other.
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I personally hope the PS3 is a huge success. I've always been a big fan of Sony consoles and will definitely be getting a PS3.
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Backwards compatability isn't a huge thing for me. Sure it'd be nice, but chances are when I get my PS3, I'll only be playing the new games for the first few months. By then I'll have the choice of either the software emulation will be good enough or wheel out the old PS2 if I really want to play the games.
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The problem is, many people have "traded" in their PS2 to get the PS3, so when it comes out they wont be able to play any games...
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