The first thing you'll need to create a custom ringtone in WP7 is an MP3 file. This file must be 40 seconds or shorter (and 1MB or smaller in size). If your MP3 is too large, you can use a program like Audacity to crop it.
After you have your MP3 file the correct size, you'll need to open Zune and make sure that the MP3 is listed in your music collection. Find it in the collection, right click on the MP3, and click on "Edit". This should bring up a window with the MP3 properties. The only real important thing here is that the genre of the song must be changed to Ringtone. See the image below.
After updating the genre to Ringtone, click the OK button, and then sync the MP3 to your phone.
Finally, on the phone, go to Settings -> ringtones+sounds, and click on the Ringtone selector. The ringtone you created should now be at the top of this list in the "Custom" section.