WARNING: You should be fine if you follow the instructions closely, but there's a slim chance you could brick you phone. And unless your restore your stock bootloader and software image before sending it back to Google, rooting the phone can void the warranty. Additionally, with any ROM flashing comes data loss—back up your important info before trying any of this. Proceed at your own risk.
1. Unlock your SPL. Your SPL is your phone's bootloader, or the software that lets your phone choose what to boot from. You know when you have to choose a boot source on your PC to install Windows? (HDD, USB, CD-ROM, etc?) It's like that, except for your phone. You need to crack this open, so you can boot from whatever you want.
First, you need to enable debug mode on your N1:
On the device, go to the home screen, press MENU, select Applications > Development, then enable USB debugging.
Then, if you're on Windows, you need to download the Android 2.1 SDK and USB driver, available here. This will give you the tools you need to talk to your Android phone from you PC, and to issue commands to it remotely. If you're on Mac, this just works.
Connect your phone to your computer via USB and do the following:
• Download and extract fastboot from here
• Run a command prompt / terminal at the directory you just extracted
• Type 'fastboot-windows oem unlock' or './fastboot-mac oem unlock' or './fastboot-linux oem unlock' (as appropriate)
And that's that.
2. Install a custom recovery image. Now that your bootloader in unlocked, you can replace it with a more powerful one. Download the recovery image from here, connect your phone to your computer again, and:
• Copy recovery-RA-nexus-v1.5.3.img to a location where fastboot can find it.
• Boot your phone into fastboot mode (power on while pressing the trackball)
• Connect your phone via usb to your pc/mac/...
• [run] "fastboot devices" (to make sure that fastboot "sees" your phone)
• [run] "fastboot flash recovery recovery-RA-nexus-v1.5.3.img"
Once that's complete, you should be able to start your phone into a new bootloader by powering on while pressing "Home." You can navigate through the menus with your scroll wheel, but not your touchscreen.
3. Install a custom ROM with multitouch. Given that Google just released the Android 2.1 source code to the public, there aren't a whole lot of options for custom ROMs. There is one, though, that includes multitouch, as well as a bevy of other small hacks. Download that here (or Google " MoDaCo Custom ROM 1.4" for mirrors; they come and go, it seems). The direct download of the ROM is currently available only to MoDaCo subscribers, but if you can't find a mirror and don't want to shell out for an ad-free subscription, just give it a few days, since it'll be more freely available—and free—before too long.
After download, you should end up with a file called "Update.zip". Copy this to your device's SD card. Boot into your device's bootloader (remember: power button + home), execute 'nandroid backup' from the menu if you'd like to back up your current device configuration, then select "apply sdcard:update.zip"
Once the operation is complete, restart your phone. The first boot may a take a while, and it's always good policy to run and Android phone through a second boot cycle after a ROM flahs, but once that's done, you've got a multitouch-capable Nexus One. Congrats!