If auto-synch is left on, of course it erases the entire library and replaces it with your iTunes library.
Could you explain the logic of this to me? Using phrases like "of course" seems erroneous to me. If I was developing an application and all I had in mind was the end user, I would handle a sync just like I would handle any other sync: merge the two things you're syncing. When you sync your phone with your computer, does it delete everything and add only new content? No. It 'syncs' which should me a node A gets info from node B and vice versa. No deleting.
The iPod sync doesn't work that way. The library on the iPod is a mirror of the one on the computer. The computer is the master device, and if you make changes to the library on the iPod, they will not be kept unless they are also made on the master library.
When the iPod is synced, the master library is what is used to determine what is on there - it's purely a mirror of the computer, not a two way sync/merge. After the release of the iPhone (and other touchscreen iDevices) the option to consolidate tracks you had downloaded elsewhere was added as part of the sync process, but in the early days when it was designed to be used with a single master library when in full auto mode, it did not do this - it simply told you that it would delete the tracks if you selected "yes, delete the tracks and sync".
Where this would trip people up is if they would load music onto their iPod manually (manual control was always an option) on one computer, then later connected it up to a computer that had automatic sync set up (iTunes warns you if it will delete files, but who reads dialog boxes, eh?), and thus any changes made to the iPod are then lost.
Adding those "third party" tracks to iTunes and syncing them to the iPod worked as it always did, or if you wanted to run with multiple different iTunes libraries you just turned off the automatic sync and just manually controlled what iTunes would copy to your iPod.
Of course, that doesn't make for very click-baity headlines or nonsense lawsuits.