I was workin on a Arduino based DIY project where i really wanted to replace some potentiometers with encoders. handling encoders in Arduino quickly becomes messy, and uses a lot of the processing power of the poor thing.
They are tiny little PCBS with an AT tiny MCU that does most of the work for you. There is even an Arduino library that you just plug into your Arduinoi code, and you can have rotary encoders that you handle over I2C.
You can get the boards without the encoder an just solder the encoder youself.
i have not found an encoder with the same formfactor as the AE potentiometeres, but i did not spend too long looking.