Okay here is what Apple has to say
Restore iPod from Disk Mode
1. Disconnect iPod from your computer.
2. Manually put iPod into Disk Mode as explained in support document 93651.
3. Open the latest version of iTunes and connect iPod.
4. Restore iPod as explained in support document 60983.
Got to love this one " If you cannot force your iPod into disk mode and restore it, then your iPod may need service"
at http://support.apple.com/kb/ts1463 now if you do a good google search you will find that some people repair it by the "slap-the-back" method. Some times when you drop your ipod the lens inside skips. This can also happen with other incidents that are not as violent as dropping it. Reset your ipod by holding the middle and menu button until you hear clicking, then with one hand hold the ipod firmly and hit the side of it onto the PALM of your other hand. Sometimes this jumps the needle back into place but not all the time. It may also require a few attempts since most of us are not willing to treat it like a 1970's TV :) NO GUARANTEES ARE MADE HERE AND I WILL NOT ASSUME RESPONSIBILITY FOR ANY DAMAGE :) There are also multiple threats out on it even answer here on ifixit Why does my iPod show a red "x" in a circle? and http://www.pinkbike.com/forum/listcommen... worst case scenario, you will need a new hard drive. Let us know how it is going and best of luck.