I'm actually using the BlitzSafe VW/M-LINK1 V.5 in my 03 Jetta. I'm a simple Ipod solution for my car keeping control on the Ipod itself and not my head unit (I'd rather it that way). I'm having the same issue with my 80gb classic. When I plug the Ipod into the interface, the touch wheel itself becomes useless, although I can still control the Ipod with the Menu, forward, back, etc. buttons. As soon as I unplug the Ipod from the interface, my click wheel goes back to normal.
One thing I also noticed is that when the Ipod is plugged in, I can see the wheel actually being used although I'm not touching it. By this I mean you can actually see the volume going up and down or the highlight bar actually moving up and down. You can also hear the Ipod clicking away.
I've talked to Blitzsafe and they told me my Ipod is faulty and to get it looked at. I've tried both a 5th Gen Video and Nano and they both worked perfectly. After reading this thread I'm sure my Ipod isn't the problem although I'd like to try another Classic just to make sure.