iPods end up in the refurbished lot for a number of reasons, some of which include being returned to Apple for various reasons. Refurbished products are overhauled to work like new; any malfunctioning parts are replaced. They are given new cases and new serial numbers so they appear to be brand new. The iPods come with the full one year of hardware coverage, and 6 months of free shipping and handling if the iPod needs to be sent back for any reason. You are also eligible to purchase the AppleCare Protection Plan, which extends your hardware coverage and free shipping and handling to 2 full years from the iPod's purchase date, which is something I highly recommend.
I have two iPods, both of which were purchased refurbished. I've had no problems with either one... the photo iPod was purchased in March 2006 so it's coming up on one year old, and I've had virtually no problems with it. The video iPod was purchased in August of 2006, so it's newer, but it has no problems. Neither iPod showed any signs of use or damage when I removed them from the packaging.
I have absolute confidence in Apple's refurbished products... in fact, my next computer will most likely be a MacBook, which I'll probably purchase refurbished for no other reason than to save money.
Hope you found this helpful.
CG