I am usually not a big fan of the wording of the CoP rules in the various publications of the ISU. But in the case of the Interpretaion component, I think they have done a pretty decent job in the listing of the criteria for "musicality."
"Musicality," like "artistry" is a rather ephemeral term -- kind of hard to pin down in words. But, yes, the description of what the judges are looking for in the Interpretation category does specifically list timing and variation of rhythm, along with style, character, mood, intensity, dynamics, matching of movement to the music's "melody, harmony, rhythm, color, texture and form" -- and a bunch of other cool-sounding stuff.
Here is the document (scroll down to item 5.)
http://www.isu.org/vsite/vfile/page/fileurl/0,11040,4844-152086-169302-64121-0-file,00.pdf
As to what the judges do with all this, that's not so clear. Some judges (just like some skaters) have a greater knowledge of music than others. Judge Joe Inman, for instance, has a reputation as a "music" judge. I believe that Mr. Inman is a professional musician or musicologist of some sort in "real life," and he consistently rewards those skaters who can "step in time" over those who can't (at least, he did under ordinal judging.)