How do I replace the rubber o-ring?

If the old o-ring is cracked, you should be able to just rip and peel it away. The best way to replace the o-ring on the encoder is to remove the encoder wheel by loosening the setscrew. A drop of oil on the inside of the new o-ring can sometimes help to slide it into place. The new o-ring can be pushed on with the help of a table surface.

You can order new o-rings here:

http://www.quilttech.com/c-120-intellistitch-parts.aspx