To place the posts under /blog/date...
in _config.yml
I changed
permalink: /blog/:year/:month/:day/:title/
to
permalink: /:year/:month/:day/:title/
This change was in addition to the instructions from http://octopress.org/docs/deploying/subdir/
That worked for the blog posts themselves, but the archives page stills show up as /blog/blog/archives
You can probably search the source for "archives" to see how that's generated if you want to fix the archives page itself and the pages that link to it. Octopress is a blogging engine for hackers after all ;)