I use my iPod with a docking station hooked via RCA into AUX input. I don't think you can hook up an iPod with a digital connection (optical or coax).
Everything I have on my iPod are MP3 recorded from my CD's at 224kbps and actually sounds pretty good. I use it almost every day for just general listening. Not quite CD quality (I have done side by side testing and can tell a difference) but still good.
As gonk said using a docking station is far superior to the headphone output.
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Outlaw 990/7700
SVS 20-39 PC +
SVS MTS-01 towers, MCS-01 center, MBS-01 surrounds
Behringer A500
Samsung PN58A650, DirecTV HR-20 700
Sony CDP-545, Phillips CDR 765
Oppo BDP-93, Panasonic DMR E515
Technics SL-DL5
Squeezebox 3
Remote Harmony One