In their latest mailbag answering session of Scribes, Rare squishes then squashes the rumor that their team is currently working on a Killer Instinct sequel stating that "purely out of contractual obligation, no, we're not working on KI3". Rare also re-emphasizes that their main focus right now is the Xbox 360 Banjo-Kazooie sequel which we're sure we'll be seeing at this year's E3.
That pretty much ends the Rare rumor squashing for today. But let it be known that their yet to be announced project after Banjo ships is totally fair game for the rumor generators among us.
Rare is so not working on Killer Instinct 3
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