Get a good 2D art program, <a href="http://www.slackiller.com/hlprograms/sprwiz.zip">Sprite Wizard</a> for creating .spr files from proper .bmp files, and <a href="http://collective.valve-erc.com/data/docs/1047496381-02062100/files/sprview.zip">SprView</a> for viewing sprites.
With that, you'll be able to convert the images you create to the game's sprite format. However, the majority of the actual creation of the sprite is in your 2D art program. Photoshop's a good one, but not a free one. I can only think of one "high level" 2D art program that is free,
GIMP. I haven't used it much myself, but I've heard good things about it. And if you've ever used Photoshop and gotten used to its interface, I hear there's a hack/port/rehash/whatever you want to call it of GIMP that makes it look and behave very much like Photoshop, called GIMPshop.
