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.