Android pays for itself, in lots of different ways, among them and by far most importantly: Being the default search provider on 550k additional phones/day. That's worth a billion $ to Google any day.
I don't think it's just about search. I think sometimes Google does things Because They Can and then try to figure out how to make money later. Android's most realistic reason for existence, IMHO, is to ensure that Google users can take their data with them. If there was no Google phone, then the world would stick with Exchange, and GMail is not Exchange.
I always thought that Android's raison d'etre was to prevent any other company from dominating the smartphone business (Apple having apparently the best shot at this, but would still apply if Microsoft or RIM seemed likely to) because they would then have a huge opportunity to cut Google out of the loop - they could use Bing for their default search engine, have a built-in mail app that's not Gmail, etc.
There's money back and forth between these companies all the time. It's just behind closed doors for 90% of it. Patent suits are the equivalent of tabloid coverage of a public argument. It could very well be resolved behind closed doors like many other suits.
