I've found that attempting to add subtitles to a video that is then encoded for MP4 (like for the iPod) results in a video without the subtitle.
So the workaround I'm using is to first encode (with the subtitle) as AVI (Divx) and then re-encode that file (now that it has the embedded subtitle) for the iPod (using either ffmpegX or MPEG Streamclip).
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