Why is Steam saying my friends are playing Hello Kitty: Island Adventure when I know they aren't?

As Gnoupi said, it's possible to report any game you want to play as a non-Steam game.

In this case, it's a joke reference to the episode "Make Love, Not Warcraft" of South Park, in which Butters prefers Hello Kitty Island Adventure over World of Warcraft.

As far as I know no such game exists.

By the way, there's a similar exploit where it is possible to show yourself playing a game which you have pre-loaded, but is not yet released, by using a utility that reports the AppID to Steam. This means you can't even trust the regular in-game titles either. I've been known to "play" Left 4 Dead 2 and Portal 2 prior to its release.

You can make Steam say you're playing anything. All you have to do is add a non-Steam game shortcut and rename it. I heard about a fantastic April Fool's prank where someone did this and named the shortcut "Half-Life 2: Episode Three." All of his friends freaked out! Pretty classic.

To add a non-Steam game to your games library, select Add Game at the bottom left of Steam and select the corresponding menu item:

Steam is not lying on such reporting, for games in their library.

It is possible to be shown as playing just about anything, since you can add a third party game to your game list, and give it the name you want. It will be written as "In a non-steam game" under, though.

Since there is no "hello kitty" game in the Steam store, I assume that this is what is done there.