I've read that there was some sort of mechanism inside the head. I suppose you'd be able to pull a lever or something, and they would wiggle. I don't know the technical aspects, although someone else on here will undoubtedly be able to tell you more about that.
I know that the mechanism was eventually removed (i.e. more recent Fozzies do not have this ability). Not sure why. My guess is either because it weighed alot, or he sort of outgrew the ear-wiggling thing.