as i understand it the arduino can only handle 10bit.
Your understanding is not correct. You are probably thinking of the Arduino analog inputs.
The encoder is digital, with a standard A/B/Z output, and as such, any of those encoders is compatible with Arduino. However, the electrical interface is TTL and may require level shifting (e.g. a 1K pullup resistor) for the Arduino CMOS inputs.
any suggestions to a stepper driver allowing microstepping is appreciated.
Buy one compatible with the current rating of the stepping motor you have in mind. Pololu has a good selection.