Through the pins; they're using the line-out capability of the dock connector so you're using the ipod's DAC rather than a DAC in the head unit. Thus the Y cable with a dock connection on one end and an AUX plug plus USB connector on the other. Amazon has a 3rd party cable for $22 that I've been using.
Note: in my experience trying a USB key, it was a pain for more than a couple gigs of music. When tried several GB of stuff the car wouldn't get done indexing the music before I got to where I was going most times and tended to pause a lot in playback. I tried a couple different USB flash drives. Doesn't happen with an ipod nano or my iphone 4S with all else the same.