Well, there's the library database file, and the 'Library', i.e. the folder containing the music. iTunes lets you set the 'Library' to anywhere you choose, but by default keeps the database file in the same place: "~/Music/iTunes/iTunes 4 Music Library". (and "~/Music/iTunes/iTunes Music Library.xml".)
The database file actually contains a pointer to the 'Library' folder.
That said, while iTunes always searches that path for the file, you can use any combination of aliases or symlinks to keep the file someplace else, including your external drive. That's what I do -- I replace my ~/Music/iTunes folder with a symlink pointing to the external drive, so I keep both the database file and the 'Library' of music there.
Be careful if you put the database file on a network drive, though -- you don't want two machines trying to write to it at the same time.