The Zune-based media player and new Windows Phone 7 both show an impressive grasp of simplicity in interface. The latter specifically shows the company's readiness to start from scratch when things have become too clumsy.
Microsoft's improved approach appears in other products as well. My colleague Chris Dannen mentioned Microsoft's mapping technology. If you haven't watched the video from the TED conference yet, check the link he included and you'll see how trying to understand what people might want from technology can leave them wowed.
I'd argue that Microsoft Surface has the potential to change how people interact with computers to a far greater extent than the iPhone. Microsoft even has a patent application on creating user-defined gesture sets.
However, as necessary as user-focused design is, Microsoft needs at least two more tools. One is reliability. Having products as gummed up as Windows Vista or as failure-prone as the Xbox 360 is enough to tank any smart design effort. Make a product unreliable enough and it will chase customers away -- no matter how attractive it may seem at first. (For proof, see, for example, the history of the British automobile industry.)
Microsoft's other major weakness is style appeal. Apple knows how to appeal to customers' self-image and their desire to be hip and cool. Microsoft's best products have never achieved that status. Yet without it, even the best products often languish. Microsoft tablet, anyone?