Yes that seems to be most of the issue, complaining that a 128kb/s track sounds s*it. I got an 80Gb iPod because I prefer the bit rate to be as high as possible. I rip CDs in an uncompressed format, and the quality of the iPod for classical music is astonishing.
Since I don't want people to know that I'm listening to an iPod or indeed to anything expensive I use JVC marshmallows when I'm wandering around. The sound quality is good and certainly adequate for use on aircraft/the street. I use AKG cans at home or play the iPod via the HiFi. The quality is as good as my CD player and that's a high-end audiophile unit.
There's a site somewhere on the web where one can get an iPod upgraded to use an external DAC, but IIRC the site mentions that the analogue output from the iPod is essentially flat and free from distortion beyond any limit of the human ear.