If I buy a legitimate licensed item, and turn it into something else
for sale, am I violating copyright?  For example, if I go to the
fabric store and buy fabric printed with Strawberry Shortcake and make
pillows to sale on eBay is that a problem? Or say I buy stickers and
paste them onto a picture frame?  I know if I were to scan the sticker
and make my own stationery big brother would come knocking on my door,
but if I embellish or modify something for resale is it ok?

I'm neither an expert (nor an official researcher) it occurs to me
that you might be violating *something* but perhaps not violating
*copyright.*  After all, in the situation you're describing, you're
not copying anything; you're taking one thing and transforming it into
another. Than might run afoul of others' trademark rights, or
merchandising rights, or other sort of rights, but perhaps *copyright*
violation isn't something you have to be worried about here.

Copyright law has a principle known as the first-sale doctrine.  The
doctrine says that once the copyright owner has received money from
the sale of a copyrighted article, her rights to recover additional
money as royalties from subsequent sellers is cut off at the "first
sale" level.  That is why you can, e.g., buy a book at the bookstore
and then re-sell it at a garage sale without having to pay the
copyright owner any additional money from your subsequent sale of the
item.

The doctrine assumes you are the lawful possessor of the copyrighted
item, i.e., the copy you are selling was properly bought and paid for
and is not pirated.

Here, the doctrine works pretty clearly for the stickers, but query
whether the owners of the copyright in Strawberry Shortcake can claim
a separate copyright in the design as applied to pillows.  See, on
those facts the first-sale doctrine only helps you if you are actually
just reselling the fabric as is.  By transforming it you may be
creating a derivative work, and the copyright owner is the only one
who can make derivative works.  Tough call, but I'd argue that you
were not really making a derivative work since the fabric is
essentially intact and unchanged, and thus you can rely on first sale.

You have intuitively surmised that the line between first sale and
derivative work is a blurry one--it depends on how much you transform
and change the original work, and there's no real bright-line test for
that.

BTW, the first-sale doctrine applies in trademark law, too.