Andrew Wilson and Patrick Baudisch of Microsoft Research have produced an excellent tutorial on creating a mouse-like pointing device that works in mid-air. I saw the video on YouTube and was seriously impressed.
Essentially the electronics of a wireless, optical mouse are re-housed in a smooth soap-like plastic container and then placed into a fluffy fabric tube. Similar to a tactile stress-reducing ball you can manipulate the fabric in various ways over the soap-like container and the optical sensor tracks the movement of the fabric and converts the actions into movement on the screen.
For fine cursor movement you slide the fabric around with your thumb. For faster movements you rotate the fabric around the container while the container stays still. And for still faster movements you can hold the fabric stationary while rotating the container just like you would a bar of soap. Check out the video for some visuals.
I was so intrigued by the video that I went out and bought a new mouse to convert and have a partially functional model to play with. The interface is very comfortable and the ability to move the cursor quickly and then do fine pixel-level adjustments requires almost no learning curve. It just comes naturally. I foresee this style of interaction becoming quite popular in the next few years.
My digital camera is inaccessible at the moment otherwise I'd post some photos of my hacky prototype. Because the mouse interaction is inverted (dragging something over the optical sensor vs vice versa) then either the up-down or left-right is reversed. I've yet been unable to find a simple mouse utility that lets me reverse one axis so for now this is an interesting prototype rather than something I can use on a daily basis.