In SharePoint 2010 there is a special control for adding favicons:

<SharePoint:SPShortcutIcon runat="server" IconUrl="/Style%20Library/favicon.ico"/>

But I found for IE 7 you need add

	<link rel="shortcut icon" href="/Style%20Library/favicon.ico">
	<link rel="icon" href="/Style%20Library/favicon.ico">

in your head tag of the master page too.


Be careful because IE sometimes caches the heck out of the favicon state. Make sure you make a new bookmark and clear the cache and close and open IE. Firefox sometimes is easier. So you may see the effect after a while

Also you can replace the icon permanently by

\Program Files\Common Files\Microsoft Shared\Web Server Extensions\14\TEMPLATE\IMAGES\