I'm not sure if it's exactly the same on VS2005, but I can do a quick walkthrough on VS2008. I think you're overcomplicating it...
You need to use a *.ico file for the icon, and it will be built into the app autoimatically once you've completed the steps below
1) In Solution Explorer, double-click the "Properties" item in your application project 2) On the "Application" tab of your now visible Properties explorer, there should be a section titled "Resources" with a radio button entry titled "Icon and Manifest".
3) Click the "Browse" button in the "Icon and Manifest" entry, and browse to your *.ico file
4) Build your application, build your CAB project, and you should be good to go.
NOTE: Sometimes, you have to close VS and re-open it for it to include your icon in the build. Also, if you decide to change the icon down the road, just follow the same steps, but then you HAVE to close VS and re-open it for the cahnge to take effect.
You can PM me if you have any other questions.
EDIT* Check
HERE for software to convert *.png files to *.ico files if you don't have software to do it already