According to Apple, the 3rd gen iPod Touch can be upgraded to iOS 5. However, you may want to confirm that your iPod is not a 2nd gen version - those can only be upgraded to 4.2.1.
Apple Support has the following information to confirm your version (full page):
iPod touch (3rd generation) features a 3.5-inch (diagonal) widescreen
multi-touch display and 32 GB or 64 GB flash drive. You can browse the
web with Safari and watch YouTube videos with Wi-Fi. You can also
search, preview, and buy songs from the iTunes Wi-Fi Music Store on
The iPod touch (3rd generation) can be distinguished from iPod touch
(2nd generation) by looking at the back of the device. In the text
below the engraving, look for the model number. iPod touch (2nd
generation) is model A1288, and iPod touch (3rd generation) is model
Also, per Apple Support - make sure that you've upgraded to iTunes 10.5 before you begin the upgrade.