What will it achieve
Firmware 2.1 is the latest firmware for the iPhone. If you have 1st generation iPhone, this upgrade will give it all the same features as the iPhone 3G except for 3G speed and the GPS feature.
Yes, you can use this method on any 1st generation iPhone with any version of the firmware!
For this method, we are all indebted to the iPhone Dev Team

What you need
• A 1st generation iPhone, doesn’t matter what firmware version or whether or not it is unlocked.
• A Mac OSX computer.
• iTunes version 8
• About half an hour or so of spare time, most of which will be spent waiting for things download and install.
• This guide (or alternatively iClarified have a guide with pictures here.

Summary
• Download the firmware 2.1, and Pwnage 2.1 and the bootloaders to your computer.
• Customise the firmware on your computer using the Pwnage tool.
• Load the newly customised firmware to the iPhone.
• Wait for the Bootneuter app to do its thing.
• All done! Too easy!

Now to break that down into BabySteps…

1. Before you begin
1.1 Be aware that I am not an expert on either computers or iPhone hacking. I’m just good at translating what the experts say. If you get into trouble following these instructions, it is more likely than not that I won’t have a clue why or what you should do about it.
1.2 Back up everything on your phone, because if you follow the recommended steps in this guide, all your content will be wiped and you'll have to reload it at the end.
1.3 Read through this guide carefully and make sure you understand and can follow all the steps.

2. Download new iPhone firmware
2.1 Connect your iPhone to your computer and open iTunes.
2.2 If you get a dialog box saying that a new version of the iPhone software is available, go to 2.3. If not, go to the iTunes menu and choose “Check for Updates”. Get rid of the message telling you that you’ve got the latest version of iTunes and then you should get the message about the new iPhone software.
2.3 In the dialog box telling you that there is new software, choose the option to “download only” without installing it.
2.4 It is not essential, but I recommend that you disconnect your phone from your computer at this point, and don't reconnect it until we get to section 6. Providing you only downloaded the new firmware and didn't install it on the phone, your phone should still be unchanged and so will still be working if you have trouble customising the new firmware on your computer.

3. Download Pwnage Tool and Bootloaders
3.1 In your web browser, download Pwnage 2.1 from 
here. or here.. It is also available in bittorent form at the Dev-Team blog, but I found that version created a whole bunch of errors when I came to install the customised software. I had no trouble with the ones I'm suggesting here.
3.2 When it has finished downloading, double click on the PwnageTool_2.1.dmg file to extract the PwnageTool.app and drag the PwnageTool.app to your Applications folder or another folder you have created for your iPhone stuff.
3.3 If you don't already have the bootloaders, in your web browser, download them from 
RapidShare or MEGAUPLOAD
3.4 When it has finished downloading, double click on the bootloaders.rar file to extract the bootloaders folder.

4. Optional Clean Up of the iPhone
4.1 If you are the cautious type, or if you have tampered with your phone a lot and know that it is probably full of junk that no longer needs to be there, you might wish to follow the BabySteps Clean-up Guide to clean it up as much as possible before upgrading.
4.2 If you are pwning your phone for the first time or upgrading from a version earlier than 2.0, then even if you don’t do the rest of the clean up, it is recommended that you delete the back-up details of your phone from iTunes before reconnecting the phone to iTunes. To delete it, disconnect your iPhone from the computer and open iTunes. From the iTunes menu, open "Preferences". Click on the "Syncing" tab. Click on the name of your iPhone in the list that comes up, and then click the "Remove Backup" button. This means that when you first connect to iTunes after you finish, you'll have to set it up as a new phone, but this is simple and quick.

5. Build Custom Software
5.1 On your computer, double click on the PwnageTool.app to open it.
5.2 Click “OK” to get past the copyright screen.
5.3 Click on the “Expert mode” icon and the “iPhone” icon. A big tick should appear on the iPhone icon. Then click on the blue arrow icon to continue.
5.4 You will be brought to the “Browse for ipsw” page. The browsing will probably occur automatically and find the right software. If not, double click on the folder where it says “Browse for ipsw”, and browse to the location of the 2.1 firmware that you downloaded. It may take you straight to the right place, but if not, it should be in /Library/iTunes/iPhone Software Updates.
5.5 Select the 2.1 software, and the Pwnage tool should go to a screen with seven icons on it, the first of which is called “General”.
5.6 Double click “General” and make sure the first and last boxes - “Activate the phone” and “Disable partition wipe-out” - are checked. You can check the “Enable baseband update” if you know you want it. Then click the blue arrow icon for the next screen.
5.7 Now in “Bootneuter settings”, you want three boxes checked: “Neuter Bootloader”, “Unlock baseband”, and “Auto delete BootNeuer.app”. Do not check “Update bootloader” unless you know what it is about and know you want it. Then click the blue arrow icon for the next screen.
5.8 At the time of writing, the Installer Packages screen is not yet activated (but the beta version of it will install anyway), the the Cydia Packages one is. You can just click on past it, or read it and work out whether you want it and how to use it if you do. Otherwise, keep clicking the next arrow until you get to the “Custom Logos settings” screen. Uncheck them both unless you like them and want them instead of the original Apple ones on your iPhone. Then click the blue arrow icon for the next screen.
5.9 This will take you back to the screen with the seven options. Double click on “Build”. (If the next two steps don’t happen, don’t worry, it has done them automatically and you can continue at step 5.12)
5.10 A red dialog will appear telling you that it can’t find the Bootloader v3.9 file and asking whether you would like it to search the web for this file. Click “No”. A similar dialog will then ask if you if you want to browse for it. Click yes, and then navigate to the Bootloaders folder you created at step 3.4 and choose the BL-39.bin file.
5.11 Another red dialog will appear telling you that it can’t find the Bootloader v4.6, and ask whether you would like it to search the web for this file. Click “No”. A similar dialog will then ask if you if you want to browse for it. Click yes, and then navigate to the Bootloaders folder you created at step 3.4 and choose the BL-46.bin file.
5.12 You will then get a “Save Custom .ipsw file” dialog, and you can choose where on your computer you want the custom firmware kept. If you don’t have somewhere else you want it, then in /Library/iTunes/iPhone Software Updates is a logical place to keep it. Click “Save”.
5.13 The “Building IPSW” screen will appear and run for up to 10 minutes. Part way through it will ask you for the password for your computer. Enter it and click OK.

6. Load the Custom Firmware onto your iPhone
6.1 When the custom firmware has finished building, a blue dialog box will appear asking you whether your iPhone has been Pwned before. If you know it has, you can click “Yes”, although there may be value in clicking “No” either way as it may do a more thorough, if slightly slower, restore.
6.2 If it is not already connected, connect your iPhone to your computer with its USB cable
6.3 Follow the onscreen guides to turn off your iPhone and put it into DFU mode. If this fails, a box will tell you so, and you can try again.
6.4 When you have successfully got it into DFU mode, the Pwnage app will give you a blue dialog box telling you so, and iTunes will open.
6.5 Click OK in the blue dialog box, and then Quit the Pwnage app. (Some people have been finding the Pwnage Tool telling them that they have failed to get the phone into DFU mode when they have actually succeeded. If iTunes is telling you that it has detected a phone in recovery mode, but the phone's screen is blank, then it is in DFU mode. If the phone's screen is showing a connect-to-iTunes icon, then it is only in recovery mode. The iTunes message is the same either way, so the phone screen is your clue. DFU mode is like a deeper coma than recovery mode. If your phone has been previously pwned, either mode will work, but if not, you need the deep coma of DFU mode. If the screen is blank and iTunes is detecting it, then you can quit Pwnage and proceed.)
6.6 iTunes will display a window which gives you the option to restore your iPhone. Hold down the “Option” key on your keyboard and click “Restore”.
6.7 This will bring up a browse window enabling you to browse to the place where you stored your customised firmware. Select it.
6.8 It will spend about ten minutes extracting the new firmware and installing it on your phone.

7. Wait for Bootneuter to do its thing
7.1 When the custom firmware has finished loading, the iPhone will reboot itself and automatically open up an application called Bootneuter. Do not interrupt this app. Let it do its thing, which takes about 5 minutes or so.
7.2 When Bootneuter has done its thing, the iPhone will reboot again, and this time it will take you directly to the home screen. Your iPhone is now activated, jailbroken, and unlocked.

8. You’re done... but...
8.1 ... you’ll now want to dock and sync your iphone. If you haven't deleted the back-up from iTunes, it will restore from the back-up and restore all your setting (all being well!).
8.2 ... if you have a problem where the phone is restored from the back-up but is still recognised as a new phone and so it keeps wanting to restore again, do the following: check that the restore has worked (springboard layout, wifi password, etc). Assuming it has, go into iTunes preferences, choose the syncing tab, and then delete the back-up of your phone. Then connect the phone again and this time choose "Set up as a new phone". That should fix the problem, and you won't have lost anything because it will now create another back-up from you restored phone.
8.3 … if you are on the Optus or Vodafone networks, you may want to download the relevant GPRS FIX from Cydia>Sections>Tweaks to enable editing of your GPRS/EDGE settings.
8.4 ... you’ll want to verify that everything is working, calls, SMSs, emails.
8.5 … your voicemail button should work (it gets the number from the Carrier List included the software). If it doesn’t, and you need to program it, open the phone dial pad and tap the following code: *5005*86*xxx# where xxx is your phone company’s voicemail number. Then tap call and after a second, the code will have been set.

Thanks laughingbird. Used this alongside another walkthrough and worked a treat.

Many thanks.

Au

Weird, got as far as browse for ipsw... selected the file i d/l from apple and its the wrong one. I did get it from a link posted a couple of weeks ago, so am assuming there have been some changes in the firmware even since then. its showing 5A357, but...

guess I better d/l again.

Had some issue with WRONG FILE - used Safari .... downloaded using Firefox and Presto

Will this be the admin p/w or the users (non admin) p/w?

Cautiously making sure I understand everything before I attempt this tonight - don't want to brick my wife's iPhone.

Try your normal password you use to log in

If I am on 1.1.2 is it necessary to check "Enable Baseband Update"?

Edit: Checked "Enabled Baseband Update" and all went well.

Anyone else think the phone is a tad slow?

Contacts are way slower. Also every now and then an app from the appstore doesn't work. Vector Pong has a dead screen for me. Can't launch the ball.

Darnit, I completely forgot to say thanks to laughingbird for his babysteps guide... as always, laughingbird, you got it right, thanks so much

Fantastic stuff!

thanks to laughingbird too.

What is this APN thing?

I am on a $79 prepay with vodafone. Does the APN thing apply to me?

I constantly get told that I am not subscribed to edge.

The APN is the Access Point Name the phone has to use to connect to get data via GPRS or EDGE. Therefore you need it if you want data when you don't have access to WiFi.

Prior to FW2.0 there was a spot in settings where you could enter it and change it if needed. In 2.0, it is apparently there if you are on Telstra, but not if you are on Vodaphone or Optus. When you upgrade with Pwnage, sometimes it puts the right APN in anyway, but I've also seen it not do so, and yours must have not done so. Even if you got it right, you might want to change it to disable expensive data if you want to.

If you just want to set it up and never touch it again, you can do it while your phone is connected to a WiFi network by going to and following the instructions there to change the APN to the correct one for your carrier. You will probably have to then reboot your phone for the change to take effect.

If you want to make it editable in future, you can make changes that give you the control panel back into settings. To do this, you need to be comfortable using SSH to play around inside your phone. If so, this guide will show you how to do it.

So if installer is not active during pwnage process can you add it latter?

What software version does the iPhone need to be running before you run pwnage, 1.1.4 or 2.0 ? And should the iPhone be restored before attempting to use pwnage or doesn't it matter ?