well the best lotr dolls that i know of can be found at Doll on the Hill Factory:
http://www.stvgr.net/dhf/
as for making them, you need an image editing program (e.g Photoshop) and a base. (DHF has pretty good bases or you can make your own). then in your program just draw clothes, hair etc. on the base. (There are many doll tutorials floating around on DHF and other sites.)
And it is possible to make dolls in MS Paint its just very hard (that's where i make my dolls.)
I'll try and upload my dolls to show you all, sadly i don't have lotr ones yet. (I don't have the patience to draw those sleves pixel by pixel!!)