Native resolution is 480x320. I believe that iTunes resizes photos automatically for you when loading them on your iPod, so you might get an improvement if the photos were pre-downsized.
You might try a little experiment... downsize and oversharpen, just downsize, just oversharpen, etc. Tag a variety of photos with a number for each process and see what looks best on the iPod touch screen.
Then create a simple Photoshop action to downsize/sharpen everything.