Step 3: The ATMEGA chip works fine without the Arduino board!
3. The ATMEGA chip works great WITHOUT the Arduino board!
Arduinos that have been pre-loaded with the "Lilypad" bootloader firmware, instead of the standard Diecimila or Uno firmware, have a very special property: after you program such an Arduino with your own code, you can then take the $3 ATMEGA168 chip out of the programmer board, supply 5V power to it (such as the power from a USB bus or cell phone charger), and it will still work the same and do the same amazing things that your $30 Arduino does, all by its lonesome! You only need the Arduino board to program the chip -- after that, the chip can fly solo!
Before you upload your code to the Arduino, you need to pre-load the Lilypad bootloader fimware. Buy an AVRISP mkII and follow the instructions here: http://arduino.cc/en/Main/Bootloader . Make sure you have "Lillypad" selected as the board you are using in the "Tools" dropdown menu of the Arduino IDE window on your computer.
UPDATE: I am not sure if the Lilypad bootloader is compatible with newer boards like the UNO, which have an auto-reset feature the Lillypad doesnt have. If you have a newer board you may or may not have to disable your board's auto-reset feature by following these instructions -- http://www.arduino.cc/playground/Main/DisablingAutoResetOnSerialConnection . Please comment if you have tried this method with an UNO -- my own board is a bit of an antique!