This is cut and pasted from techTV.com --
The feature you refer to is known as the favorites icon, found in Microsoft's IE 5. The favorite icon feature allows a website to place a customized icon in the address bar or favorites menu instead of the normal IE icon when a visitor bookmarks your site.
To implement the feature, you need to use an icon editor. Leo likes Microangelo, which you can download at the ZDNet Software Library.
Once you have the editor open, create an icon at 16 by 16. The icon will actually increase to 32 by 32 when it is dragged from the address bar and placed on the desktop. When you create your icon, check that it looks good at the higher resolution as well.
You can create the image in any number of colors, but IE 5 will be decolored to 16. Save the icon as favicon.ico and upload to the server.
The file can reside anywhere on the server that contains viewable HTML files, but the root of your webpage is the best location. IE 5 will automatically search for the favicon.ico file and place the icon on all pages hotlinked from the root page.
What Buraje said is also correct -- it works both ways...
in the head of the page that you want the icon to show up when bookmarked with a relative path to the icon:
<LINK REL="SHORTCUT ICON" href="your_image.ico">
--Paul Prewett