Windows Icon (ICO) file format is used for Windows file icons, as well as the favicon on webpages. I had to create this from time to time and have found the free aaICO Icon Editor to be a good tool for the task. However, the application has quite a lot of problems when run in Windows 7. The following is the process I use to workaround the various problems.
Use any image editor to create a 48 x 48 pixels image of the icon. Save it in a PNG file format, which can handle transparency. Once the PNG file is ready, use aaICO to convert it to an ICO file. This is done by using the Import feature in aaICO, which is under the File menu. On the import options dialog, select all the icon sizes you would like to have included in the resulting ICO file. Check the Resample option so that the image is resampled, rather than simply scaled, when the smaller icon sizes are generated.