Our iTunes guru Terence Devlin advises the following:
1. Quit iTunes
2. Drag the iTunes folder from your internal hd - located in ~/Music folder - to your external hd (which has to be formatted as HFS Extended (Journaled)). DO NOT delete the original one from your internal hd... yet!
3. When the transfer is complete, press and hold the Option(alt) key and fire up iTunes.
4. A "Choose iTunes Library" window will come up. Click on the "Choose Library" button.
5. Navigate to where the iTunes folder is located in the external hd.
6. Within the iTunes folder, select the iTunes Library file and click Choose...
That's it. iTunes will now display all your playlists, songs, movies, podcasts etc. At this point, should you wish, you can delete the iTunes folder from the internal hd to free up space.
Or if you prefer a more complicated explanation: