This past fall, my friend Jane and I took a Felted Bag class at our local yarn shop. I fell in love with felting -- and, although, I'm certainly not an expert on either knitting or felting -- by trial/error, I've developed a 'recipe' for creating felted bags.
For a small bag -- with size 13 needles and 100% wool yarn (using two strands of yarn), cast on approximately 18 to 24 stitches. Knit plain old garter stitch until you've knit a rectangle, bind off loosely. With a circular (size 13), pick up stitches all around the knitted rectangle and knit in the round to almost the size you want your bag to be -- place stitch markers to mark button-hole handle placement. Between markers, bind off for both handles, next round cast on the number of stitchers you bound off +2 or 4 stitches. Continue knitting in the round for 4-6 more rows. Bind off loosely and trim any loose ends. For a little fancy touch, you can add a strand of fuzzy yarn for a fews rows in the body of the bag - this won't felt but will add some texture to your bag (see the two light blue rows). As you can see, the pre-felted bag is about 8 1/2 x 11 inches. Felted bags can be made in any size - just remember that the knitted bag will felt 40-60% in stitch height and at least 20% in stitch length. With that fact in mind - you will need to knit your bag larger than the finished felted bag. More information can be found on Raverly.
Place the unfelted bag in a cotton pillow protector (with zipper closing) along with a couple of tennis balls. Set your top-loading washer on hot water setting on lowest water level. When machine begins to agitate, add your bag (in the pillowcase protector). Set a timer for 6 minutes and check bag by removing from hotwater (a pair of gloves is handy for this process because that water is hot !) -- if you still see stitch definition, put bag (in the pillow protector) back into the washer and agitate for additional 3-5 minutes. This is not a process you want to wander away from -- stay close to the washer and check the felting progress often. When felted to your liking, squeeze as much of the hot water as you can before removing from the washer. Rinse bag in cold water and then roll in a towel to remove excess water. At this point, I usually throw the felted bag into the dryer with a couple of towels and dry for 15-20 minutes on low. Remove from dryer and place folded towel inside bag to continue drying overnight. I find that it's better to have the towel be a really tight fit to give the finished bag a smoother finish. Remove the towel and let air-dry overnight, remove towel and continue to air-dry for a couple of days. Beware -- you can't make just one of these bags -- they are totally addictive !
Place the unfelted bag in a cotton pillow protector (with zipper closing) along with a couple of tennis balls. Set your top-loading washer on hot water setting on lowest water level. When machine begins to agitate, add your bag (in the pillowcase protector). Set a timer for 6 minutes and check bag by removing from hotwater (a pair of gloves is handy for this process because that water is hot !) -- if you still see stitch definition, put bag (in the pillow protector) back into the washer and agitate for additional 3-5 minutes. This is not a process you want to wander away from -- stay close to the washer and check the felting progress often. When felted to your liking, squeeze as much of the hot water as you can before removing from the washer. Rinse bag in cold water and then roll in a towel to remove excess water. At this point, I usually throw the felted bag into the dryer with a couple of towels and dry for 15-20 minutes on low. Remove from dryer and place folded towel inside bag to continue drying overnight. I find that it's better to have the towel be a really tight fit to give the finished bag a smoother finish. Remove the towel and let air-dry overnight, remove towel and continue to air-dry for a couple of days. Beware -- you can't make just one of these bags -- they are totally addictive ! 
