My understanding is that technically it should be called fulling, but anyway it is knitting or crocheting something much larger than you want for the finished project and then agitating in water until it shrinks to the desired size. Wool is the best known yarn and I don't know if there is another fiber out there that shrinks under similar handling. Most of the felted or fulled items I've seen patterns for are purses, hats, and slippers. I'm sure there are a lot of other items out there as well.
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