Dion appears to be going against his French instincts by refusing to surrender on this one. If he sticks to his guns, I don't think we'll see much political fallout from this, if only because it's easy to wrap yourself in the flag when defending it - "Canada is a great country because it is made up of people from many backgrounds. My loyalty is unquestionably to this great country which is why I've spent my life fighting for it." Or something like that.
Still, the question of whether the Prime Minister should be allowed to have dual citizenship is a tricky one. Michaëlle Jean gave up her French citizenship after she was named Governor General and if we're going to require that of a figurehead, surely the same standard should be applied to the leader of the government, n'est-ce-pas?
So while Dion could certainly hold his own in the duel over dual citizenship, in my opinion he likely should voluntarily give it up as a sign he's ready to be Prime Minister.