This is a little howto about sharing internet with dnsmasq and Ubuntu.

Firstly let's create a script which will clean netfilter's routing tables, set up packet forwarding rules and allow only required services. Create firewall script in /etc/rc.firewall and append this script call to /etc/rc.local:

#!/bin/bash

# Echo commands and abort on errors
set -x
set -e

# Define network interfaces:
IFACE_WAN=eth0
IFACE_LAN=eth1

# Clean
iptables -P INPUT ACCEPT
iptables -P FORWARD ACCEPT
iptables -P OUTPUT ACCEPT
iptables -F
iptables -t nat -F

# Do masquerade
iptables -A FORWARD -i $IFACE_WAN -o $IFACE_LAN -m state --state ESTABLISHED,RELATED -j ACCEPT
iptables -A FORWARD -i $IFACE_LAN -o $IFACE_WAN -j ACCEPT
iptables -t nat -A POSTROUTING -o $IFACE_WAN -j MASQUERADE

# Enable packet forwarding
echo 1 > /proc/sys/net/ipv4/ip_forward

# Allow DHCP and DNS requests from LAN
iptables -A INPUT -p udp -i $IFACE_LAN --dport 67 -j ACCEPT
iptables -A INPUT -p udp -i $IFACE_LAN --dport 53 -j ACCEPT

Set executable bit and run it:

sudo chmod +x /etc/rc.firewall
sudo /etc/rc.firewall

Next step is to install dnsmasq:

sudo apt-get install dnsmasq

Create dnsmasq configuration file in /etc/dnsmasq.conf:

no-poll
domain-needed
bogus-priv
strict-order
interface=eth1
bind-interfaces
dhcp-range=192.168.0.10,192.168.0.200,255.255.255.0,48h
dhcp-leasefile=/tmp/dnsmasq-leases.txt
dhcp-authoritative
resolv-file=/etc/resolv.conf.upstream
log-queries

Next configure network interfaces in /etc/network/interfaces:

# The loopback network interface
auto lo
iface lo inet loopback

# WAN
auto eth0
iface eth0 inet dhcp
    post-up cp /etc/resolv.conf /etc/resolv.conf.upstream
    post-up echo "nameserver 127.0.0.1" > /etc/resolv.conf

# LAN
auto eth1
iface eth1 inet static
    address 192.168.0.1
    netmask 255.255.255.0

Finally restart all the services:

sudo /etc/init.d/networking restart
sudo /etc/init.d/dnsmasq restart

If you have internet coming in on eth0 and other computers connected via eth1, they should receive proper IP address and DNS configuration from dnsmasq and internet sharing should work.