The reason the input setup just lists "analog" as a choice is that each input has its own analog connection, and that's the connection each input will use when analog is selected. I'm not sure why you'd get sound carrying over from one source while another was selected. The connectors aren't brushing each other on the rear panel, are they? If they were touching, the signal from the iPod's Monster cable could be getting into the Xbox's cables somehow (unlikely, but I suppose not impossible).

I've only connected my iPod with an analog cable connected to the headphone jack, and agree that it's far from an audiophile source - although mzpro5's one of a number of people I've seen report that using a dock helps. Is there a reason you haven't run an optical cable from the Xbox360? I was thinking that the 360 supported DD 5.1 audio in games, which would only be available from a digital connection.