I use Latin-1 (aka ISO-8859-1) in the Terminal, because äöü is all I need, and it works well. I gave Unicode a quick try, but didn't get it to run properly, i.e. from the keyboard into bash or emacs, and out via cat and less.
My Latin-1 setup is as follows. In ~/.bashrc I have
export LESSCHARSET=latin1
export CHARSET=latin1
In ~/.emacs:
(set-terminal-coding-system 'iso-latin-1)
(set-keyboard-coding-system 'iso-latin-1)
The Terminal "Window Settings", Display, is set to Latin-1 too.
Seems like the UNIX world never really gets above anything else than 7-bit ASCII. I would *love* to see all tools use Unicode, but that won't probably happen anytime soon.