It is possible to make an AR application for iPhone 3.1 that does live image processing (I've done one for myself).
Here is a good tutorial with working sample code for 2.x http://www.morethantechnical.com/2009/07/01/augmented-reality-on-the-iphone-using-nyartoolkit-w-code/
For 3.1, you'll need to replace the camera video grabbing code. Tip: PLCameraController _createPreviewIOSurface.
Note that you can't submit such apps to the App Store because of the use of private API.
