Create an "ext" Partion

First of all: This step is completely optional, but it will
dramatically increase the available space for installing apps on your
phone. If you don’t care for more space, continue to step 4.

Still here? Good! You’ll need a few things:

• More than 1GB of free space on your SD card (actually, 1GB is the absolute minimum, the more, the better, but i suggest at least 3GB).
  
• Basic knowledge of Linux and partitioning, as you could loose all
  the data on your sd card if you don’t know what you’re doing – don’t
  just blindly type the commands, use your brain!
  
• [optional but recommended]: A backup of the data on your SD card.
  

We’ll now partition your SD card, such that it contains a FAT32
partition for holding your regular SD data (like pictures, music etc)
and an ext3 partition which can be used by CyanogenMod for your apps.

Update (2012-01-21): I received a few reports of errors with
tune2fs, and I’m happy to tell you that this issue is fixed. Nadlabak
(the creator of CyanogenMod for Milestone) has provided an updated
tune2fs binary (a statically linked one, in contrast to the old,
dynamically linked one) which i have included in my OpenRecovery v1.46
download. Please download the updated version if you ran into problems
with tune2fs before. After rebooting into OR you’ll have to unmount your
ext partition before you execute tune2fs:

umount /sddata

For those of you who just started with this guide: you should already
have downloaded the updated version in step 1, so you can safely ignore
the last paragraph.

• If you’re not in OR, reboot into OR as described in step 3.
  
• Select “Console” to enter the OR console and verify that you
  selected the correct keyboard layout. If the layout is not correct you
  can type “exit” to exit the console and return to the OR menu, where you
  can change the layout (settings/Keyboard Layout).
  
• Unmount your SD card.
  

  umount /sdcard

• Start parted, a partition editor (inside parted, the backspace
  button doesn’t work, so take extra care not to mistype anything!).
  

  parted /dev/block/mmcblk0

• Print the partition table of your SD card.
  

  print

• You should now see something like this, and it’s important that you
  write down a number now: the exact size of your SD card. There should be
  a line like
  

  Disk /dev/block/mmcblk0: xxxxMB

  (in my case: 7969MB). If you have more than one partition (i.e. more
  than one line in the table), please stop here and ask someone for help,
  as you don’t seem to have formatted your SD card from inside Android.
  
  SD card partition table before SD-Ext preperation
  
• Resize the FAT32 partition to leave 1GB of free space at the end of
  the SD card. The resize commands takes 3 arguments: The partition number
  (1), the new start of the partition (the start of the SD card, 0MB) and
  the new end of the partition (the size of the SD card – 1024MB, 6945MB
  in my case).
  

  resize 1 0MB 6945MB

• Create a new ext2 partition (parted doesn’t support formatting to
  ext3) at the end of the SD card, using all the free space (1024MB). The
  mkpartfs command takes 4 arguments, the type of the partition (primary),
  the filesystem (ext2), the start of the new partition (we want it to
  start where the fat32 partition ends, so 6945MB in my case) and the end
  of the new partition (this is the size of the SD card, 7969MB in my
  case).
  

  mkpartfs primary ext2 6945MB 7969MB

• Verify that everything’s ok, your new partition table should look
  approximately like that (actually that picture shows the partition table
  after the ext2 to ext3 conversion, at this point the filesystem of your
  second partition should be ext2):
  

  print

  SD card partition table after SD-Ext preperation
  
• If everything went well, exit parted:
  

  quit

• Convert the new partition to ext3:
  

  tune2fs -j /dev/block/mmcblk0p2

• If you encountered no error messages you have successfully
  partitioned your SD card! Now exit the the console and return to the OR.
  

  exit

Update (2012-01-17): To make use of this partition, you’ll have to
install your apps to “phone memory” from CyanogenMod. Under the hood,
your “phone memory” is extended by the 1GB ext3 partition on your SD
card, but if you install an app to your SD card from within Android, it
will go to the FAT32 partition (which we don’t want). CyanogenMod even
offers a setting to always install apps to internal memory: Settings
-> CyanogenMod settings -> Application -> Install location
-> Internal. Another advantage of having an app on internal memory
(i.e. on the ext3 partition) is that the app will be available even if
your phone is connected to your computer. If the app is installed on the
SD card (i.e. on the FAT32 partition) it will disappear as soon as you
connect the phone to your computer.

Update (2012-03-12): CyanogenMod will not display the extended space
in the Manage Applications screen, only the internal storage will be
taken into account. But you’ll notice that you’ll have much more free
space than before (with the same apps installed).