What is the difference between in-lens image stabilizing and sensor-based image stabilizing?

And which one is more effective?

Answer

In lens stabilisation contains a servo activated rear element which acts to move the image projected by the lens in order to cancel out the camera shake.

In body stabilisation moves the sensor in order to counter camera shake.

No method is clearly better, and discussion tends to turn into a brand war as Canon and Nikon don't offer (and are not likely to offer) a body based solution, and therefore must adopt/reinforce the view than in-lens is better.

In lens stabilisation:

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  Can be tuned to the requirements of a specific lens. Telephoto lenses are likely to show a different pattern of blur (more linear, over a shorter time period) than wider angles, which have to stabilise the image for longer, where an oscillatory motion may be present.

  
  


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  The in-lens method stabilises what you see in the viewfinder for easier composition.

  
  



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  You can get hybrid systems that counter both angular and translational movement, which is important when the distance the subject is small. Currently the only exmaple is Canon's 100mm f/2.8L macro.

  
  


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  Works with all bodies, including film / older digital bodies, however most people have more lenses than bodies!

  
  

In body stabilisation

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  Provides stabilisation for every lens you mount, even old MF designs. Since stabilised lenses are almost always more expensive and stabilisation only exists on certain models this is a considerable plus.

  
  


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  No extra elements in the optical path to potentially flare or disperse light.

  
  


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  Can correct rotational movement and can automatically level the horizon.

  
  


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  Astronomical tracking mount like features are available on some models (such as the Pentax K-5, thanks John).

  
  
  

I've seen some tests that indicate the in lens stabilisation can perform better, however you do have to pay for it in every lens, see Image Stabilization Testing on SLRgear. It makes sense to me than in lens could perform slightly better as you're comparing a system designed for a specific focal length to a system that has to try and work in every situation. There's no reason in principle you couldn't have in-body stabilisation and then turn it off and use in-lens for some lenses for maximum performance.