From a historical perspective, we've seen huge leaps in the graphical sophistication of videogames -- compare Pong to Bioshock and they're just worlds apart, even though under the hood they're doing exactly the same sorts of things. The current generation of consoles just does it all much, much faster, with a bigger palette to draw from (and on) and hardcore support for 3-D math. And that has produced some very impressive results.
I am inclined to think that the law of diminishing returns is starting to kick in, however. It was a huge leap from black-and-white, color-stripped Space Invaders to Galaxian in full color; the NES era had a limited color palette but delivered sufficient resolution to allow some differentiation in art style among publishers and developers. The SNES generation improved on that with better color (and sound); then the Playstation brought consistent 3-D to the table. And then... what? Well, the Dreamcast upped the resolution to 480 lines; the PS2 included hardware support for 1080i, though it went largely unused; and the modern consoles support full HD, except the Wii which tops out at 480p. There are other measures, of course -- draw distance essentially became a minor concern with the PS2 generation, and bump mapping has only come into its own recently. There are lots of little things that can be done to improve the realism of computer graphics.
But where do we really expect to go from here? It's hard to imagine that the next generation of consoles will do very much that looks different from this generation. There's always the "real time ray-tracing" target, of course, but ray-tracing tends to look geometric and computerish, not organic, and I'm not sure it's really the holy grail of graphics technology it's made out to be. Resolution (for televisions, anyway) and color depth are maxing out. I think we will continue to see better physics, more consistent frame rates, more heavily-textured and layered polygons, and more moving objects. But all of these advances will be incremental improvements, not revolutionary steps forward. Eventually we will have filled the screen with pixels doing interesting things, and find that there's not really anywhere else to go on that front. There's true 3-D, of course, but that's more of a display technology (possibly requiring a 120 Hz refresh rate, I should note) than an image generation advance.
So it will be interesting to see what happens in the "next generation". My expectation is that Wii 2.0 will look more like the PS3/360 generation, because it could definitely stand to catch up a bit. But what about the PS4/720/what-have-you? Seriously, from here on out I expect the "wow" factor of graphical advances to start wearing off. Even handhelds will eventually catch up with their console brethren on the cosmetic front.
And I hope that means we'll see game design return to the forefront. Innovation for the past few decades has gone largely into improving the audiovisuals, and I appreciate the benefits of those advances. But there's something about technological constraints that seemed to unleash developers' creativity back in the day. The current retro/downloadable trend has produced some fine contemporary examples like World of Goo and Braid -- it's easier to take risks with lower budgets, and technological targets that don't require doubling your graphics staff each generation. And as the investment curve in new graphics possibilities starts to level off, I hope we will see developers freed to take bigger, more interesting risks.