Gem update: unable to convert “\xE7” to UTF-8 in conversion from ASCII-8BIT to UTF-8 to US-ASCII

I have had a similar issue on my Mac OS X using iTerm2 instead of the default OS X Terminal.app.
The LC_CTYPE is not set properly by iTerm2, once I have added export LC_CTYPE="utf-8" to ~/.bash_profile the gem installation goes smoothly.

note: of course you can add the export to any of the other profile files