Step 1.

For some background, check out:
http://blog.atebits.com/2009/03/not-your-average-iphone-screencast/

Step 2.

AWESOME SCREENCASTS
http://www.youtube.com/watch?v=L0nPXFseHg0

Step 3.

Enjoy, fork away, email [email protected] when you make it moar better and want me to check out your changes.

Step 4.

I've added a few new features to SimFinger that we needed over here at Improbable Sciences. 
Activating Caps Lock will hide the 'finger' while you're recording with a nice fade in/fade out animation.
Additionally, you can constrain the pointer overlay to the iPhone's screen.