Make sure that the yarn you are using is 100% wool. Otherwise it won't felt, but it may stretch. Alpaca and llama may also felt. Also make sure it doesn't say "Suitable for washing machines" or "Super wash" anywhere on it.
Knit your item keeping in mind your item will shrink when felted more or less 40%, depending on how many times you wash it. Note that the more you wash it, the thicker it will get. Also, felting is irreversible, so make sure you really want your item felted before doing so.
Sew up any seams (if you have any) with a yarn needle, but do not sew on any buttons. That will be done after felting. If you use the same yarn you used for the knitting, when it's done your item will look like there aren't any seams at all.
Wash in a top loader washer (if you don't have one, go to a relatives house or a laundromat, because your item will turn out better in the top loader. The item will get to actually sit in the water, where in the front loaders, they would just get spun around.) with hot water. If it is not hot, it will not felt. Wash about 3 times without detergent.
Lay some towels out on a flat surface, place the felted item on top, and gently stuff with more towels to absorb the water. Let it dry for about 2 days, flipping the item every once in a while.
Add decorations with a needle and thread.
Give, sell, or enjoy your new felted item!