There are a lot of different ways of working with felt. The simplest way is to buy felt pre-made from the store and use it as fabric for sewing projects. You can also make your own felt from wool roving by doing a process called "wet felting." Another way to make felt is by washing and drying an old sweater-the heat will fuse the fibers together to make felt!
Needle felting is a way of pushing wool fibers together with a special type of needle. This process does not require water or heat. Basically, you take a piece of wool roving and arrange it over a piece of fabric (perhaps a blouse or a bag that you'd like to embellish?), then place the whole apparatus over a foam block or mat and start rapidly poking at the wool with your needle. You can use templates or stencils to make different shapes. Even cookie cutters would work. (I sense an ugly Christmas sweater project...)
You can even make 3-D needle felted projects by shaping the wool into whatever you want to make, or attaching felt to a foam base.
Keep in mind:
The needles used in needle felting are really sharp! Consider protecting your fingers so you don't poke yourself.
If you're felting in the dryer, you should put your fabric in a mesh bag to avoid a clogged, fiber-filled washer and dryer. Also empty your lint catcher frequently.
Try adding a pair of jeans to the load to "agitate" your felt more and get a better result.