You've put a LED in series with the iPod. Thus all the voltage is dropped by the LED and there's not enough left to poewr the iPod. Try this:
Connect the two red wires you've cut together and also connect them to the anode of your LED. Then cut the black wire, strip them back, connect them together and then connect them to the cathode side of the LED. Now you've hooked the LED up in parallel with the iPod. When there is power to the iPod the LED will light, but the iPod will have the full amount of voltage and current necessary to charge the battery.
I've been working in electronics for 12 years now.
16GB iPod Touch, 60GB Video, 2GB Nano, 1GB Shuffle
5537 songs, 17.1 days, 36.1 GB