Also, released a functionality for website owners to provide an additional level of privacy for visitors to their sites by offering an option to anonymize IP address information sent to Google. Analytics uses IP address of website visitors to provide general geographic reporting. Website owners can now choose to have Google Analytics store and use only a portion of IP address for geographic reports. Keep in mind, that using this functionality will somewhat reduce accuracy of geographic data in your Analytics reports.
You can learn how to implement this within your existing Google Analytics installation here: