It's basically a matter of creating a .jpg at 1024x1024 pixels and sticking it into the LFS/data/skins folder. The result needs to come out at 400kb or under to be ideal, and if you want to use it online then you need to visit the LFS world link at the top of this page, click "My online skins" and upload it, that way your opponents can see your skin too.
The skins folder is evidently full of the skins that your game is currently using, and it's also where you should save any that you download. As suggested by Al, if you visit Master Skinners, you will find some excellent resources including 2048x2048 pixel wireframe skin templates in .psd format. They are absolutely the resource that I have found thus far for making skins.