Onlive is the next step in "The New Age of Desktop Computing". Onlive is an example of providing online access to a series of applications requiring fast, local compute resources. As more streaming HD-like video services become available online, it is natural to expect that an all-you-can-play gaming service would prop-up. Gamers with desires to play the latest games either have to invest in a powerful console (such as an XBOX360 or a PS3) and live with the hardware's limitations until a next-generation console is released, or upgrade your PC regularly. To run the latest games at the highest settings on a PC, one would be investing in new graphics cards, which may be purchased as early as every few months to as late as every couple of years, and the processor and memory limitations would require one to build a new computer every couple of years. For example, Crisis is a game that modern gaming PCs continue to struggle with at high resolutions.
I think that it's quite possible for something like Onlive to work; with a high throughput connection, one can stream at up to 1080p (albeit with more compression and possibly less quality than locally) without having to upgrade one's PC everytime the next generation of games are released. Control signals (such as mouse and keyboard input) do not requirement much in terms of bandwidth, but they are very demanding in terms of latency. There's a reason why gaming mice exist: to increase the resolution and physical-to-digital capabilities of one's input to the PC, and all that information needs to be transmitted very quickly to the remote servers to provide that ideal fast, remote compute system experience. Given possible deals to provide gaming as a service through transmission line companies (i.e. cable, phone, etc.) or local data centers (i.e Google), the company would be in the position to install systems at locations that can provide low latency to the gamers and provide a good experience.
As the gaming industry begins to surpass the movie industry, one can envision people willing to pay a monthly subscription fee similar to cable to be able to play unlimited games anytime, without having to use a powerful console or PC. Most likely, Onlive's largest issue will be its capacity to scale; games are power-hungry and will require huge compute farms based on the number of users in that local area, and these compute farms need to be duplicated in local environments to provide low latency to users. This will likely be more expensive to run than Youtube, given that Youtube only has to transcode the content once and serve there-in. This will be an interesting company to follow...don't be surprised if a large transmission line or Internet company ends up buying them in the near future.
See also: Engadget