It's going to depend on how the war goes. If the surge works and Iraq is more stable come 2008 then Iraq isn't the issue and it's back to basic party differences. If the surge doesn't work and we're still mired down then the Democrats will probably clean up.
I'm going to take issue with your point about it "all hinging on Iraq."
The Democrats, along with their supporters in the MSM, are fixing in the public mind that Iraq is a failure. They can & will maintain this conclusion right through the election. Nothing short of a troop withdawal will change the public perception.
Liberal Democrats & the MSM are knee-jerk anti-war. They will hold together in this conspiracy. Second, they have convinced the mushy-middle to focus on US casualties as the measure of 'progress'. Notice that when US casualties drop for a period that they switch to reporting Iraqi civilian casualties. As long as the Iraqi insurgents supply the MSM with a steady drumbeat of Iraqi casualties, the MSM will trumpet this as emblematic of Bush (read Republican) failure.
What the Republicans need to do is Spread-the-Floor -- engage the Democrats on a whole range of issues and espouse conservative values. Give the voters a choice. Then we win.