How do I create a virtual machine on Windows 7?

What you heard of is known as XP Mode for Windows 7, which is basically a Microsoft VirtualPC image (free for licensees of Windows 7 Professional and Ultimate) to run Windows XP applications within Windows 7.

Other than that, you can still use your virtualizer of choice (e.g. VirtualBox, Microsoft VPC or VMware) and create your own virtual machine.

I've installed VirtualBox on Windows 7 for this purpose and it works great.

You can still install the latest version of Microsoft Virtual PC on other versions of Windows 7 but unless you have Ultimate or Enterprise you'll need to have a valid license for installing the guest OS as these versions include a specially licensed copy of Windows XP. If you're not interested in Windows XP then it doesn't really matter.