What is the best compressed iTunes format?

All iPod's are not created equal. They use different DACs in different ones. The 5G, 30GB iPod video uses a Wofson DAC. The current models use a proprietary DAC that Apple developed themselves, I think. Its not Wolfson, I know that. There are also differences in power and cicuit design.
I have not done a test like this, but let me ask a few ?s:
Was your vinyl guy listening to the same song on both iPods?
Does this person have an iPod himself, is he used to having earbuds in?
The difference I hear between lossless and compressed iPod files is in the extreme frequencies - there is more detail in the low/high end with lossless files. Its something I had to listen for, and its more noticeable on some tracks than others. For example, the re-mix that Jimmy Page did on the entire Led Zepplin back catalog did not reveal more dynamic range in the recordings; this is not music I would recommend for a test like this. Tool is good. Electronica or IDM is good. Classical would work.
I have never A/B'd lossless vs. compressed in a blind test, then tried to ID the lossless rip. I will try to do this soon. I might surprise myself, and re-rip my entire library into 128 .mp3.
Eh...Probably not!
Also consider that Apple Lossless is not really lossless - it is a variable compression at a very high average bitrate, using a very efficient codec (MPEG4 I think). AIFF, WAV and FLAC are true lossless formats. Not sure if this would have made a difference in your test, but that was great to read about.

My coworker listens to headphones at work often and isn't an iPod owner. I set him up to listen to the same song that came from the same CD and iTunes computer. I didn't tell him anything beyond giving them both a listen and report if he heard any difference.

The funny thing was that he wanted to know what was different in the two iPods that could make them sound so different (this is my reading between the lines paraphrase). It was clear that he heard a difference and said the 128 AAC sounded fuller.

A test doesn't get any more blind than this, but this isn't a perfect test. Maybe I'll revese the files and let him try it again and see if the iPod rules or if the format rules.

ALAC is indeed 'lossless' in the sense that you can re-create a bit-accurate copy of the original file.....from the ALAC file.
The very definition of lossless:

Magfan I am cornfused - if ALAC is lossless, why do I get different readings on different ALAC files for bitrate, when querying them in iTunes or in Windows Explorer? For example AIFF always shows 1411 kbps. But ALAC files are all over the place. Is this because the ALAC compression is variable, and I am getting an average reading, like I hypothesize above? Incidentally I did some research and yeah its lossless. The bitrates are winding me up.

Mysterious stuff, no? No accounting for (or predicting) synergies, daffy combos, or personal taste -- far as I'm concerned. I've got a pair of Grado RS-80s that I use on the AAC stuff through the iPad/pod, mostly to and from work on the subway. Like'em just fine for that, in fact, think they sound surprisingly great. But when I tried the Grados on the home rig (all AIFF, Ayre QB-9, dedicated Headroom Home amp for the cans), it was downright unlistenable. Strident, harsh, painful, even. Plain couldn't do it. Actually, I was entirely floored by how genuinely unpleasant it was. Go figure? (But, then, my baseline for cans is Senn HD-600s with Cardas wires, which have got to be near as dark and syrupy as it comes....).

Anyway, not totally surprised to hear that, at least in some cases, there appear to be significant variances in iPod DACs / hardware. I can attest that the itunes software has been noticeably improving on the sonic end also, for what thats worth. Maybe something driver end? Could also be that the hardware at issue was in fact designed to optimize, balance or otherwise sound best with lower bitrate material? Gosh, I'm really reaching here.... Generally, I always assumed that the differences in sound through an iPod would be dominated by factors other than file format to the point where differences in software format wouldn't be particularly determinative. My basis form this assumption? Well, nothing whatsoever, actually. Just a guess that I've been happy enough to just go with. Anyway, very interesting "hard" results. And even more interesting when it's not what you expected going in. Keep us posted. Cheers.