I'm afraid this is a common problem (happens on every iPod model that I've owned -- that's five different models -- early 2nd generation iPod, shuffle 1, shuffle 2, iPhone, and nano). Basically, any of the equalizers that boost the bass frequencies will distort when playing at anything other than the very lowest volume settings. Of course, the source material affects the results as any bass heavy recording will have more of a problem. I suspect this happens because the iPods don't have enough output power to cleanly drive such high levels of bass. In fact, I suspect this is a common problem on a lot of MP3 players (not just the iPods).
The workaround (if you want to call it that) is to use only the mildest forms of equalization and then keep the volume levels fairly low. Because of this I almost never use equalization on the iPods. A better solution is just to use a set of headphones that are both efficient (low power) and which have better bass response. For that purpose I can recommend either the Koss Porta Pros or the Sennheiser PX100s (note, these are headband style, on-the-ear type headphones, NOT earbuds).