It is illegal to make a pair of jeans and then attach a designer brand
label, this I know.  Is the following scenario illegal?  If I buy a
pair of designer jeans, remove the label, die them, cut them, fray
them, and modify them in various ways, then attach my own label to the
jeans and sell them, is that illegal?  If so, why?  After all, I can
take a Hershey's chocolate bar and combine it with other products, and
sell the new dish?  Why wouldn't that apply to jeans?

I can't imagine such a thing would be illegal, after all it happens all the time...

from http://www.xmission.com/~dempsey/shelby/sheldodg.htm

The Shelby story actually goes back to the days of the Cobra. Carroll
Shelby was building a race car and searching for an engine; Lee
Iacocca was working for Ford and was the individual to whom Carroll
pitched his idea. The deal became reality, the car became a success on
racetracks around the world, and the two men became lifelong friends.

****

At this point, Carroll opened his own shop. Rather than continuing to
produce Shelby-inspired Dodges, he began to build actual Shelbys -
cars he purchased from Dodge, modified, then sold himself through
select Dodge dealers. These vehicles typically came optioned one way
only - Shelby's way - thus any one should be identical to the others
(exceptions will be noted). Each model was a one-year run; each car
received a dash plaque engraved with Shelby's signature and bearing
its Shelby production number

My guess would be that it depends how you are selling it, if you are
selling it to a few friends or very small scale on ebay and being
honest saying it's your creation, then no one would really be bother
since would it really be possible to identify the jeans as someone
else's design?
   If you go over a small sale selling for extra "pocket money" then
i'm guessing it could be a different kettle of fish altogether.
  Just make sure you make it very difficult to identify the jeans
origins and don't leave say fly buttons that say perhaps "diesel"
written on them.

Both of you made good points.  We do, however, live in a very litigous
society.  What charge do you think Diesel would accuse me of if they
wanted me to stop.  Or, if Dodge didn't want Shelby to continue, what
charge would they accuse Shelby of?