Amended and updated 7th March 2011 to hopefully make the process easier to follow and to include some great tips provided by others throughout this thread.
You may have noticed that users of this forum have created cool avatar badges that are displayed to the left of their posts. Strictly speaking, this Lithium software is designed to let you have a small avatar image in the top left of your badge. The badges themselves come with a few pre-defined backgrounds, but you can also upload your own image for a background. Being the creative sort we SL users are, we have adopted these badge backgrounds as a way to have a larger, more attractive avatar image (or other image of choice).
This quide is designed to help you create a cool badge too! 
(1) Get some inspiration!
Firstly, before you begin to create your badge, you might want to have a browse through this thread and take a look at all the lovely badges people have created. This may give you some ideas and inspiration for creating your own badge as people have come up with lots of clever ideas. You can use an image of your avatar, logos for your business, another image you like and even animated gifs. I would, however, caution you against making a badge that is overly spammy, rude or otherwise breaks the Participation Guidelines
(2) Get ready to create your image!
When you are ready to create your badge, open up your preferred image editing software. Photoshop is what I use, but you can also use the freely available GIMP software (or any other image software that you prefer). I'm assuming a basic knowledge in how to create an image and use your preferred image editing software. If you are completely new to image editing though, have a search on Google for some beginner's guides for your chosen software. Also, if you are new to taking snapshots in Second Life and want to use a photo of your avatar from inworld on your badge, have a read of the snapshots guide on the Knowledge Base here (You'll need to save an inworld snapshot to your computer, then open it in your image editing software to use on the image you are going to create for your badge).
(3) Create you blank area for your badge image!
Ok, now you need to create a blank image of the right dimensions for your forum badge. Make your image in a program such as Photoshop or Gimp with dimensions of Width=170pixels and Height=195pixels. These are (roughly) the right dimensions for the badge. Note that the actual size of the displayed badge can change depending on what part of the forum you are in, or what amount of data you have displayed on your badge. In some instances you could find that your badge image is tiled vertically. However, my suggested dimensions should work ok in most circumstances if you are careful about what data you display on your badge (more on that later in section 6).
(4) Add the image you want to use!
Once you have your blank 170x195 image you can add whatever image you want to it. I would advise that you leave a small amount of 'border' around your badge to cater for some of the differences in sizing I mentioned above. To give you a rough idea of how your badge might look, compare my 'raw' background image below to how it actually appears on my badge to the left:
You need to also pay some attention to how the text on your badge will display. Note in particular that your name will be displayed in black text and all other writing will be in white or light grey. Therefore, you need to consider how these areas of text will contrast with the lighting on your background image. This is a little tricky as you need to ensure the background behind your name text is sufficiently light so as to not clash with the black text of your name and, conversely, you need to ensure that the background behind the other text is sufficiently dark so as not to clash with the white \ grey text! Currently, it is not possible to change the colour of this text so proceed carefully. I would strongly advise you to save your image template so that you can go back and edit it as you may need to upload it to the forums and make a few adjustments once you see how it looks with the text.
You can use features such as 'Lighting Effects' (in Photoshop) to create light and dark shaded areas. Adding a slight transparency to your image can also help to lighten it.
(5) Decide on your badge style!
Once you have created your background image you now need to upload it to use on your badge. When you are logged in to the forums click 'My Settings' (top right on the black navigation bar). Now go to the 'Social Connect' tab. Tick the box that says "Display your profile badge on your posts". Note that you now have the option of selecting one of four pre-defined badge styles. This is where it gets a little bit complicated! If you select a pre-defined style, elements of it will still be used even when your upload your own background image. However, you can choose to not use one of these pre-defined styles and just upload your background image. Before you proceed any further, take a look at the examples below to get an idea of how your badge might look depending on what choice you make. You can ignore the 'splat' and 'moderntech' styles as these will completely block your own background image.
No pre-defined style Using the 'bayfog' style Using the 'tokyo madness' style
Note that using no pre-defined style will give you a white bar for your statistics plus light grey text; the 'bayfog' style will give you a transparent grey bar with blue hashes and white text; the 'tokyo madness' style will give you three transparent grey boxes with white text.
It is also important to note that once you choose one of the pre-defined styles it is very difficult to revert back to the 'no pre-defined style' option. So if you want that option don't click on one of the pre-defined styles! (If you did use one of the pre-defined styles and really want to revert back to the 'no pre-defined style' see 'Pro Tip 1' at the bottom of this post for a possible solution!)
(6) Choose the elements to be shown on your badge!
Before you choose your style and upload your background image. I would recommend you make sure the tick boxes for 'Blog articles' and 'Ideas' are turned OFF. It is pointless to have these elements wasting space on your badge as 'Blog articles' are for Linden staff only and 'Ideas' is a feature not currently implemented here. It is up to you whether you have 'Topics' and 'Accepted solutions' checked to show on your badge. 'Topics' will show the number of new threads (not posts) you create and 'Accepted solutions' will show the number of answers you have had accepted if you answer questions in the 'Answers' section. Note that your actually post count will always be shown as will your 'rank' and registered date.
(7) Upload your image and create your badge!
Once you have decided what style to use, click that style and now click the 'Browse' button to upload your own background image (don't click any of the themes if you want 'no pre-defined style' though, just click the 'Browse' button!). Now click the 'Browse' button again from the pop-up window (next to 'select a file'). Wait for the file to upload and then click 'Insert Image' leaving the image size as 'full size'. Your background image will now be uploaded for your badge and shown in the preview on the right of the 'Socil Connect' tab. However, don't pay too much attention to this preview as the dimensions of you badge will look slightly different on the actual forums! Be sure to click the 'Save Changes' button at the bottom of the 'Social Connect' page and then go to one of your posts in the forums to see how your badge looks. If you are happy with the way it looks - wooo hoooo! Congratulations If you need to do some editing, go back to your image editing software, make the edits and then follow the process above again to upload your image and apply it to your badge.
(8) Choose your smaller avatar icon!
You will notice that you also have a smaller avatar icon at the top left of your badge. You can either change this to another small image of your choice, or make it completely blank to just show your main badge image. If you want to use another small image (as is the case for the three badge examples shown above) you first need to upload that image. To do so go to your profile and click the 'View images for [your name]' link from the pane on the right. Then click the browse button to upload your image. Now go to 'My settings' and then to the 'Avatar' tab. Choose 'from uploaded images' and select the image you just uploaded to use as your small avatar icon.
If you do not want a smaller avatar icon you can achieve this by uploading a full transparent image as a .png file and applying this as your avatar icon. Note that there is one small downside to using a blank avatar icon in that you won't have any profile image at all displayed next to your name at the top of your profile page. (Thanks to Kalynn Carnell for this tip!)
(9) Pro tips!
Pro Tip 1
If you have used a pre-defined badge style and really, really want to revert back to the 'no pre-defined style' there is one possible way to revert back, but you need to use firefox and have firebug installed, then right clicking beside the tokyo madness theme, selecting "inspect element" then opening that element and editing the one below it in the "value =" and setting it to "tb_none" I would only do this if you know what you are doing though! Thanks to Void Singer for this tip!
Pro Tip 2
If you have uploaded a few versions of your badge as your were making edits to get it to look right, you might want to delete the old versions to save space (we are currently limited to 100 uploaded images). To delete the old versions go to your profile by clicking on your name from the black navigation bar (top right). Now click 'View images for [your name]' from the images pane on the right of your profile. Hover over the 'Image Options' link and turn on batch processing. Tick all the images you want to delete, hover over 'image options' again and choose 'Delete all checked images'.
See example below: Thanks to ab Vanmoer for this tip!
I hope you found this guide useful! I know it's quite long but I've tried to included as much info as possible and included various tips from people throughout thi thread. Do have a read through this thread too as there are more great tips that I may have missed. I'll try to update this post if and when anything changes regarding the badges.
Also thanks to various people I have quoted and used example badges from including but not limited to Keli Kyrie, Quinn Morani, Void Singer, Kalynn Carnell, ab Vanmoer and Pamela Galli.
Good luck creating your badge!
Yours rocks Keli! I'm guessing you were sensible enough not to use one of the existing badges which screws things up a little 
I'm going to have another play with mine tomorrow as I want to get my photo larger like yours. The problem is the black text of my name becomes hard to read when it overlaps my hair or sweater (i refuse to go blonde though! lol)
