dead pixels or scratched screen?

Yes but very expensive. Buff the scratch out with car wax and a soft cloth. Pixels problem, read this:

http://docs.info.apple.com/article.html?artnum=22194

i cant imagine minor scratches affecting the picture that much.. if you have a local Apple Store, i would take it there, and see what they say... yes, you can send it in for repair, and they will replace the front, but I can imagine that it would be costly.

but when
I tried to exchange it at Best Buy, they wouldn't
take it because they said the discoloration was due
to the small scraches on the screen. I knew that the
screen had gotten a little scratched, but I didn't
think it would distort the picture that much!

It wouldn't. A few surface scratches - which are actually on the case, not on the screen itself - don't cause that amount (or even that sort) of distortion; you'd have to smash the front of it with your fist or sit on it to cause that kind of damage.

Best Buy is notorious for trying to prevent customers from making legitimate returns. How did you pay for the iPod, cash or credit card? If you used cash, you're probably at the mercy of Best Buy, but if you used a card, just call the number on the back of the card, tell them you were sold a defective product, the seller won't let you return it, and you want to file a complaint. The customer service rep will explain the details to you; you'll have to print out a form, fill it out and snail mail it in to the credit card company, but it's worth it. (Do this soon; by law you only have 60 days to file such a complaint.) The credit card company will investigate, and if they determine Best Buy sold you a defective product, you don't have to pay for it. That sort of leverage, once you take advantage of it, usually leads to the retailing caving in to the consumer rather quickly.

Even if you did pay cash, you should go back to BB anyway, ask to speak to the top manager, and demand a replacement or refund. Be polite, but be firm, and keep asking for higher and higher supervisors until you get what you want.

By the way, in the future, admit to nothing whenever you need to return any product anywhere. I'm not saying that if you spill a beer down the back of your brand new TV that you should try to take it back and lie about the obvious cause of the malfunction. But if you put a minor scratch on something that has nothing to do with the problem you discover soon afterwards (as is likely the case with your new iPod), then take it back and if questioned, say "it was like that right out of the box" and stick to it. As long as we live in a world where employees at places like Best Buy are under orders to do everything possible to stop legitimate returns, you're under no moral obligation to hand them a ready-made excuse to refuse to take the item back.