I just recently discovered how to set MP3's as ringtones on the T-Mobile G1. It's not a very straight forward process so I have taken some screenshots to show you how it's done.
The first thing you have to do is open the music player and go to your list of songs. Choose which song you would like to use as the ringtone and long-press on it. This will bring up a menu that includes the option to use as phone ringtone. Once you select that option it will show a dialog confirming that the song has been set as the ringtone for the phone.
That also added the song to the list of possible ringtones so that now it can be used for a particular contact instead of simply as the default ringtone for the phone. To set the MP3 as the ringtone for a contact simply go to your contacts and edit the contact you want to change. Click the ringtone dropdown option and you will see the MP3 is now in that list. Select that option and save the contact. Now you're all set!