What sound quality is best for ipod?

There's no way to confidently make a good answer: it depends on your musical preferences. I have a Nano and Touch, as well as a few phones, and have found that - at least for me 320kbs mp3 is fine with nearly all my music. 

However, if your music was imported from vinyl and digitized for your players, you'll probably have to double your sample rate. 

If you don't have it already, download Foobar 2000 and also get the ABX plug in. Then go to youtube and search on Foobar ABX and find one of the better (most viewed) videos on how to make it work (it's easy once you know how, but not obvious at first).

You can then do your own blind comparisons between file formats on your PC using your E7 and the same headphones. You can compare 320K, 192K VBR, 256K VBR to FLAC. The ABX plugin lets you hide your score so you can make several guesses as to which you think is which, and then see how you did. If you scored close to 50/50 it means you very likely can't tell any difference. It's best to always use the FLAC (or WAV--they sound the same) file as one of the two and compare each of the lossy compression files to that. If they sound the same, you have a winner. Pick the smallest filesize that sounds the same.

And you should rip all the compressed files from the same original WAV file so they're all at the same level. If you can hear a level difference, it's easy to tell the two apart.

Have a look at the HydrogenAudio forum if you want to know more about Foobar, ABX, etc.

The lossless/FLAC vs. 320Kbps is an ongoing debate, there are a number of threads with many detailed posts on the subject but IMHO it is a very subjective thing.  Personally all the stuff on my ipod classic is 320Kbps and I can't tell the difference. 

I cannot really tell the difference between 192 and 320 but definitely between 128 and 320 or flac.

With MP3 and AAC, use CBR. With FLAC, use VBR. Too bad iPods can't play FLAC, but there is Apple Lossless.

I have been experimenting with AAC, AIFF and FLAC. I tried AAC and AIFF on a Gen 5.5 Ipod and then loaded Rockbox onto the iPod and tried FLAC and AAC. AAC rate was 256 VBR. All EQ's were flat. AIFF and FLAC are lossless.

I was amplifying through a HeadRoom Ultra Micro Amp into HD650's and Grado 225i. The feed was from the dock using a Kimber interconnect. I listened to some simple clean tracks and very complex tracks, which can often get muddled.

There were some very subtle ABA differences but ultimately there was nothing in there that would enable to me, after say an hour or two, to go back and identify which version I was listening to, in isolation. For all the effort of Rockbox, it's an admirable crusade, the clunky interface got in the way of selecting music and playing it. If I needed specialist EQ, then that would be a different story.

Is this outcome to be expected?

I shall try the same from the iMac, when I get my outboard DAC and see if it is the iPod which is the limiting factor.