You can do this effect in various image editing software, such as Paint.NET, Photoshop, Paint Shop Pro, Gimp, etc. I will be showing you how to do it in Paint Shop Pro 7. If you are familiar with your software, then this will easily be transferable. This is extremely easy to do, so I will give it one star. (*)
Go from
this to
this!
Step 1. Get your image. I will be using
this picture of Puppet Zelda.
Step 2. Duplicate the layer. You can do this one of two ways in PSP.

Step 3. Go to effects > blur > Gaussian blur
Step 4. Set the radius to whatever you want. I prefer 3.00.
The bigger the radius, the more 'painted' your image will look, and vice versa. This image shows the painted effect at a 1.00, 3.00, and 5.00 radius.
Step 5. Go to the layer properties. Select the layer blend mode 'Darken'. After than, you can play with the opacity of the layer, depending on how much you want the effect to show through.
You're finished! This is my final product:
Other examples:
