I assume that they would do this by sniffing packets, but doesn't this
all go down the drain if packets are encrypted? I'm trying to think of
how they can detect this kind of activity if packets are encrypted.
I suppose that when the encryption key is sent over a BitTorrent
client, the ISP could intercept the key and then see everything. Would
that be feasible?
If encryption keys were sent in clear over the internet, I think we would have bigger problems than the government spying on our torrents. There's this neat thing called public-key cryptography which solves this problem. Properly implemented cryptography cannot be defeated passively simply by observing packets (no matter how hard you wish for it) without years of mathematical analysis (cryptanalysis).
But I doubt most of the people torrenting in the USA encrypt their torrent activity. In fact, I'd bet than less than 2% do it. Whether it is cost-effective to hunt after those 2% is up to the government (hint: it's not).
So, yes, it all goes down the drain if communications are properly encrypted, but it doesn't matter here. The goal is not to stop 100% of illegal file sharing - just enough to make an example (and get money).
Other than that, they could rely on general usage statistics, such as
"this guy uses a ton of bandwidth especially during nighttime. He is
probably sharing files illegally." Would they take action on such weak
Someone downloading terabytes of data every month would probably get more attention than some granny using her computer to send two emails every year, but they certainly would need more evidence before any sort of action can be taken. And in any case, if you are illegally downloading files and the FBI knock at your door, you can probably invoke the fifth as revealing your activities would qualify as self-incrimination without the support of prior evidence (disclaimer: IANAL).
That said, such evidence can be obtained from "suspects" without them knowing, even though it might be technically illegal it has been known to happen (such as eavesdropping on someone's computer display - which is not encrypted and clearly shows the torrents going on) or snapshotting his hard drive while he's off buying groceries or something. A false sense of security is worse than no security.
Torrents also have an additional problem, being p2p. If someone you connected to to download your stuff is incriminated, they can potentially trace that to you, using this as evidence...
Overall I doubt this law will be heavily enforced, really. The logistics required to scan for illegal sharing on a national scale are immense and it will probably be very inefficient and miss a lot of stuff. The ISP's will uphold this regulation in the laziest way possible and a couple people might get convicted and made an example of, then everybody will forget about it, most likely.