I already have a pattern for this up on my blog, but some people found the directions a bit confusing so I thought I'd how-to it as well :-) Don't be thrown off by the fact that the how-to one looks different, the basic structure is the same, I just made another one for this purpose.
You'll need size 7 circular needles and some worsted weight yarn. Choose something with some give to it, wool is great. Things that won't hold their shape, like cotton, are not as good.
It's not super crucial, but you want a gauge of about 7 stitches to the inch in k1, p1 rib, unstretched.
Cast on 126 stitches, or slightly more if you have a big head, but make sure it's an even number. Use a stretchy cast on, like long-tail. Place marker and join, and work one round k1, p1 rib.
Ignore the fact that I don't have a marker there...err.
At the beginning of the next round, do a yarn over and then purl the next two stitches together. Then continue working in k1, p1 rib as you were.
Work in k1, p1 rib for 3 inches. If you want stripes or anything like that, go for it.
Fold the piece in half with the button hole/round marker at one end. Using another needle, do a 3-needle bind off. (You can find instructions for this elsewhere..or you can bind the whole thing off, fold it in half and seam it instead.)
Turn the piece inside out so the seam is on the inside now. You will have a strange looking canoe-like thing.
Opposite the yarn over/button hole, sew a button of an appropriate size (ie...it fits through the hole but not too easily.)
Weave in ends, and if you feel like it, embellish. (This was a fairly experimental embellishment and I'm not a very good crocheter, so if you want crocheted circles you'll have to figure them out on your own :-P) Just make sure the embellishments aren't going to hamper the stretchiness... I used an elasticized cotton yarn so it could stretch along with the headband.)
Now to get the dang thing on, since it's sort of a weird shape...lay it like this. I also recommend putting your hair up if it's long...it'll help.
Flip it over and plop it on your head like so.
Stretch it really hard, and button in the back. It will probably be really tight at first, but it will stretch out over time. You want to start a bit tight so it doesn't stretch out TOO much. If you used wool or something similar, you should be able to block it back into shape if it stretches too much.
Wear proudly, and in my case, pretend you don't look a bit like a katamari ball.