I like this little Rotary Encoder chip
LS7184N
http://www.lsicsi.com/encoders.htm
http://www.edgeelectronics.com/manufacturer.asp?name=lsi_computer_systems_lsicsi
Gives a nice clean pulse and direction (hi/low) as the knob is turned.
1 resistor sets the clock width that comes out.
Use a bunch connected with PCINTs to signal that a pulse has come in.
When one does, read the direction line and then act accordingly.
Gemini seems to have them in stock
LS7183_LS7184.pdf (190 KB)