First, we would have to spin up a Ubuntu 12.10 x64 droplet:

Next, login to your droplet via SSH as root.

Step 1 - Install eJabberd

apt-get -y install ejabberd

Step 2 - Setup Admin User

Change "password" to your own value:

ejabberdctl register admin localhost password

Give Admin Privileges

By default, hostname used by eJabberd is 'localhost', which can be modified from config file.

For our example we will call our admin user "admin@localhost" and modify the following lines in /etc/ejabberd/ejabberd.cfg:

%% Admin user
{acl, admin, {user, "admin", "localhost"}}.

%% Hostname
{hosts, ["localhost"]}.

Restart eJabberd

service ejabberd restart

Now you can navigate to your eJabberd Web Admin interface on droplet's IP address port 5280

 
http://198.199.90.115:5280/admin

The login username is user@domain ("admin@localhost" in our case):

From the web admin interface you can modify all the settings:

Adding New Users

From web admin interface, click Virtual Hosts -> localhost -> Users

You can also add a user from command line via SSH:

Now you can install a client like Pidgin to connect to XMPP:

Remember to use port 5222 to connect to your XMPP server using encryption:

Adding Users to your Buddy List

From Pidgin you can either press CTRL+B or from menu "Buddies" -> "Add Buddy" to buddies:

Your buddy would receive a friend request that they would have to authorize:

Now you will be able to communicate securely using XMPP and OTR encryption module in Pidgin:

And you are all done!