There are lots of wonderful Japanese craft books (you can find many of them on eBay or Amazon's Japan site) that show how to make all kinds of things out of craft felt...especially mascots (little animals, etc), flowers, and food items.
I've been wanting to try to make a felt cupcake, and as it turns out, I just did a little Google search and found instructions on Craftster. I'm making other things out of felt right now - including a cake I hope to have finished next week - but 100% of the credit for the pattern on this particular cupcake goes to the tutorial by AOI (here). It is just great!
Here's my version, a little different because I used 'sprinkles' rather than the cream puff and strawberry AOI used (I really like hers too!):
Two colors of felt - one for the cupcake (cake part) and the other for the color icing you want.
Embroidery floss in each of the two colors (or you could even use complementary colors if you like)
(if you make my version then you'll also need clear jewelry string and some pretty little beads for the 'sprinkles')
Cut out circles from both colors - you can use anything circular as your pattern that's about the size you want the bottom of the cupcake to be.
Cut out a length of the cake portion equal to the circumference of the circle, and as wide as you want the cake part to be tall. (BTW, you can cut the lengths longer than the circumference, then cut them down once you get sewing in case you're afraid of making them too short to go around, which would be a problem)
Cut out a length of the icing portion equal to the circumference of the circle, as wide as you want the icing to be, scalloping the edge so it looks pretty.
Sew the bottom circle and the cake strip together at the bottom, then sew up the edge of the cake.
Next, work on the icing part. Sew the icing circle and the icing scallop together, then sew the edges of the icing scallop together (just like you did with the cake).
Here's where I did the cupcake differently - I thought pretty little pastel beads would be pretty as 'sprinkles' on top. I took some clear jewelry string, made a knot in one end, then poked it through the felt (it's strong enough to poke through the felt without a needle or anything). Just take the end through the felt, string on a bead, then poke the jewelry string back through to the back side. Just repeat that over and over until you like the amount of sprinkles and tie off with a knot on the back side again.
Just stuff the cupcake bottom (on mine, the white part) with lots of cottony stuffing, and sew the top on, by threading the scallop edge to the cake part. Voila! I need to work on my needlework super-bad, but I am *so* happy with how they turned out.