Last time I managed to boot Ubuntu and Linux Mint from ISO pretty easily. Unfortunately, Fedora does not work so simply. There is no iso-scan parameter that can be used for it.
Fedora uses Dracut to create its initramfs infrastructure. From that page, I found the rdshell parameter that could be added to the kernel command line to get into a shell before switching to the real root and init. Once there, I was able to mount the USB drive, then the ISO, and finally the actual live image. So I knew that it should be possible to boot from ISO, but the initramfs doesn't have any parameter to look for it. And useful for later, I found the the version of dracut was 002-13.4.git8f397a9b.fc12.
I went looking at the Dracut pages a little more, and it turns out that support for booting off an ISO was added, and is in dracut-004. Which is great, except of course, it means it's not on the existing image. The commit was easy to find, and seemed self-contained, so I figured I might be able to patch the existing initramfs myself. It would probably be better to just build it from scratch, but I don't think I have everything installed for it and it didn't look like too big of a change to do manually. Modifying the initramfs was simple:
mount -o loop Fedora-12-i686-Live.iso /mnt/cdrom
zcat /mnt/cdrom/isolinux/initrd0.img | cpio -iV
# Modify files here
find . | cpio -oVH newc | gzip > /media/LiveLinux/boot/F12-i686-initrd.img
Now for that modify step, you need to look at the install script of the 90dmsquash-live module to see where dracut would be installing the modified files. Anyway, that seemed to work up until getting past dracut. I saw plymouth start up, but then the kernel complained about the invalid root. Obviously, the ISO was not actually mounted in the end. I even booted to the dracut shell and found no trace of the USB drive. I'm waiting to see if the comments on bug 557426 will help explain something.