There are a few ways to do iPod stuff, and there are tradeoffs to some of the methods. Finding out what method a stereo, or in car solution uses is sometimes very difficult.

Method 1 is like Mark describes, where in the head unit simply knows how to read the raw music files off the mass storage presented iPod. Some go to the extra effort of decoding the iPod database. This solution is not Apple approved, and is not a licensed method either. This is because it is not guaranteed to work. If the user has a Mac formatted iPod, this method fails, as it assumes the drive is FAT32 and not HFS+. It will also fail with the iPod Touch and iPhone, as they do not present storage over USB. If the head unit/stereo is also reading the database directly, there is no gaurentee Apple won't change the format and break things. This has happened in the past when they added some checksums and other sanity checks to the growing database, causing a community uproar that they were trying to shut out competition. Lastly, it doesn't decode the protected AAC files from iTunes.

Method 2 is the supported way by Apple, and this is the solution they license out. The head unit will talk to the iPod in a way that puts the iPod into a remote control state. The head unit can query what songs are available, categories, and so on. It can provide a raw bitstream, or a line out audio feed, and also supports playing back DRM files, as the iPod takes care of the DRM protections. This method works with any iPod with a dock, and doesn't break if the iPod is a Mac formatted unit or an iPhone. It also provides a benefit in that play counts are updated, positions are saved in podcasts, and generally things work just like they do if using the device directly. This then allows for smart playlists and syncing to work better on smaller units, as you can cycle music off the device as it is listened to, and add new stuff in.

Centrafuse in my car uses method 1, and it's frustrating because I can't just plug my iPhone in and listen to podcasts that sync to it. Instead, I have to hook the phone in via normal audio line in, and I can't control it via the screen on the in dash PC.