Take a look at the "PNGetc" pdf on (url="http://"http://www.ellrx.com/articles/vault/index.html")ellrx's website(/url). I find his writing style to be very difficult to read (I'm very anal about the proper use of written English) but you may find it useful, and it's the only full writeup I can think of offhand.
Here's my basic understanding of the process - I've made alpha-masked (transparent) pngs that work in Coldstone, but it's been a while, so I'm operating mostly from memory. Note also that I use Photoshop 5.5, so menus and such may be different for you.
Bring up the Channels palette (grouped with Layers and Paths on my system) and use its dropdown menu to select "New Channel..." This will add an alpha (transparency) channel to your image. If you turn this channel on and the other channels off, it will be shown as a grayscale image, in which white represents "fully opaque", black "fully transparent", and the shades of gray are all the levels between.
For soft shadows for windows and such, what generally works is to have the entire "background" around the window be solid black in color, and have the alpha channel fade from near-opaque at the edge of the window to fully transparent further away.
Once you have an alpha channel that appears to be correct, "Save a Copy", select PNG as the save format, and make sure the "Exclude Alpha Channels" checkbox is turned off. This should create a working image.
If you want some example files to see how a valid file should look, take a look at the png files in Coldstone Art Lib -> Medieval Outdoors -> FX_AnimFrames.
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'You can either be on the stage, just a performer, just going through the lines...or you can be outside it, and know how the script works, where the scenery hangs, and where the trapdoors are. Isn't that better?'
-- T. Pratchett