This article is from the alt.usage.english FAQ, by Mark Israel firstname.lastname@example.org with numerous contributions by others.
A bee's "corbiculae", or pollen-baskets, are located on its
tibiae (midsegments of its legs). The phrase "the bee's knees",
meaning "the height of excellence", became popular in the U.S. in
the 1920s, along with "the cat's whiskers" (possibly from the use
of these in radio crystal sets), "the cat's pajamas" (pyjamas were
still new enough to be daring), and similar phrases which made less
sense and didn't endure: "the eel's ankle", "the elephant's
instep", "the snake's hip". Stories in circulation about the
phrase's origin include: "b's and e's", short for "be-alls and
end-alls"; and a corruption of "business".