Instructables
You'll need:
1 (or more) old t-shirts
Sharp scissors

1. Start by cutting off the sleeves of the t-shirt, and then cut open one of the side seams.
2. The yarn is made by turning the piece of t-shirt fabric into a continuous strip. To do this, start on one side, and cut one straight line, roughly 20mm from the base, to around 20mm from the opposite edge. At the end you're now at, move 20mm above the cut line, and cut a straight line from the edge to 20mm from the other end. The 3rd image (black and white) shows a rough diagram of how to cut - it's important not to cut the strips all the way off, otherwise you end up with lots of individual strips rather than a continuous piece
3. Continue with the long straight cuts until you run out of t-shirt - you may have to stop before you get to the top, or cut the chest pieces (between the sleeves) as seperate strands.
4. Ball up and use! For a  very dense fabric (pot stands, oven mitts, etc) I'd suggest something in the region of 15mm needles/hooks, and for a looser fabric (scarves, garments, accessories) I'd aim for a 20mm.