So I dropped my iPhone 3G from about 1 1/2 feet off the ground, on to hardwood (not pavement). The microphone on it is now broken but the iPhone itself is not scuffed at all. I cannot open the phone up to see any physical hardware damage but do you think Apple will know it's physical damage?
The problem is that if they find out it's physical damage, I have to pay the price of the phone.

Try to find a friend who knows a thing or two about the iphone and ask them to take a peek inside. It could be the case that something just came loose. That happened to me before...granted it was with a laptop, but it was just a cord that came out of the socket....