Here is a similar project for linear position tracking:
http://benkrasnow.blogspot.com/2010/02/linear-position-tracking-with.html

This joystick is designed for use in MEG and MRI scanners where the electronics may interfere with the scanner's operation.
Fiber transmitter and receivers:
Avago HFBR-2412TZ (mouser)
Avago HFBR-1414TZ
Quadrature decoder:
Avago HCTL-2032-SC (mouser)
Fiberoptic cables:
62.5 um glass fiber custom cables from http://www.ecablemart.com/
Code wheel from http://usdigital.com/