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I have heard of people using stepper motors, but don't know how it's done.

The robot I built is a lot like EddieBot. (https://code.google.com/p/yertle-bot/wiki/YertlePictures) I used these encoders from RobotShop:http://www.robotshop.com/lynxmotion-qme-01-quadrature-encoder-1.html, with these wheels & motors: http://www.robotshop.com/solutions-cubed-ezr1-black-1.html. I used an Arduino to read out the encoders.

I've tried cheaper encoders (in this project: https://code.google.com/p/knex-ros/), but the accuracy was not very good. It was a good way to get started and learn though.