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.
Step 2: Seperating the Halves
2. Unscrew the screw, holding the 2 halves together to make sure they don't fly apart.
3. Remove the screw side cover. Be Careful not to lose the tiny ball bearing that acts as the latching mechanism to keep the cable extended. If you lose this, the headphones will not stay extended.
4. Put the ball bearing in a safe location.
Step 3: Taking It Apart
2. Take note of how the old cable was routed through the hub. You will want to route the headphone cables the same way.
3. Remove the old cable from the hub.
4. You should be left with some parts that look like the picture.
Step 4: Insert the Headphone Cable in the Hub
2. Insert the headphone cable center into the hub the same way that the other cable was routed.
Step 5: Re-Assemble the Retraction Mechanism
1. The spring has to go through the slot in the center axle.
2. I wound the spring up fairly tightly before placing the wires through the guides, such that I would be assembling it in an extended state.
3. Carefully place the ball bearing in the track.
4. Place the top cover with the screw hole back on.
5. Screw the 2 halves back together.
6. Test out the retraction to see how well it works. It should retract all the way to the audio connector. If not, then you may need to remove the top cover again, and wind it a little tighter. Although, you do want the spring pull to be weak when it's fully retracted.