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So I thought maybe I could switch the paper and blue e with something else for example a picture of a dog (Adam's dictionary of dogs). But I don't think I can use a standard Jpeg or Gif image. Do icon files need to be created in a special way?
<link rel="shortcut icon" href="/favicon.ico">
It's a specific format, however there are a lot of online tools for converting common image types to .ico if you don't have image software that supports it.
The Coalman has covered the rest. One thing to add - if you use absolute ref your favicon will show up more consistently in IE.
png2ico is a command line app for this, it's free and easy. You create the two images, save them as .png, then run the program via command line/DOS: png2ico favicon.ico file1.png file32.png [press enter]. It's a snap, make sure to make a donation when you download it, this is one of the gold nuggets of the Internet. :-)