There's still a short length between the split and the earbuds that doesn't get pulled in, but I haven't had problems with that tangling.
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Step 1: Parts You Will Need
1. A retractable cable of some sort. There are many different types available, and most will probably work. I used a treo 650 sync cable. The cable is a flat type, but the headphone cables fit in there just fine.
NOTE: There are lots of different types of retracting cable assemblies, and some may work much better then others, so this may require some experimentation. Make sure that the headphone cables are small enough to fit through the guides. Also, the whole cable length needs to be able to fit within the retractor when retracted. Ideally, it would work best salvaging the retractor from a crappy pair of retractable headphones.
2. Tangled rats nest of an iPhone headset / headphones.
3. Small phillips screwdriver.
4. Steady hands and patience.