Why is the iPod Touch 5th gen able to record 1080p yet the iPhone 4 isn't? Looking at the specs, both the iPod Touch 5th gen and the iPhone 4 have five megapixel rear facing cameras. 

Why, then, is the iPod Touch 5th gen able to record 1080p while the iPhone 4 is only able to record 720p?

Is this a software limitation, or is there something better about the iPod Touch's hardware?
Camera sensors are not only limited in their resolution, but also in the rate at which the image data can be read off of them.

Just because a sensor can take 5-megapixel still images doesn't mean that all of that data can be read off the sensor fast enough to record (smooth) video. Even reading just a subset of the pixels (called pixel binning) to reduce the amount of data may not be enough to get 1080p images at, say, 30 frames per second.

A web search indicates that the iPhone 4 uses an Omnivision OV5650 sensor. According to Omnivision's own product sheet for that sensor, it's limited to 720p video, so it's not just a software thing. I couldn't find any specifics about the sensor in the new iPod touch, but it's almost certainly a different one if it records 1080p.