Step 1: Upgrade iTunes
Before you go to update your IOS please make is sure that you have latest version of iTunes on your computer. You can download iTunes 9.2 From Download.com. After updating your iTunes you may need to restart your PC.
Step 2: Connect your device
After successfull updation of iTunes, connect your iPod Touch or iPhone to your PC using the USB cable. At the step iTunes launch automatically, if it doesn't then you can launch it manually.
Step 3: Select device
Once your device is connected with iTunes, select your device in the iTunes sidebar (If multiple devices are there in list), this will show the summer page as shown in picture. Search for the button "Check for Upgate" but don't click yet.
Step 4: Create back up
Just for safety, always make a backup before installing any updates of firmware. To do this, right-click on your device icon in the iTunes sidebar and click Back Up. It will take a minute to create a backup. If something goes wrong during your upgrade to IOS, you can use this backup to restore your orevious settings.
Step 5: Check for updates
Now, from the device summery page, just click the "Check for Update" button. If your iPhone or iPod is compatible with IOS4, iTunes will promt you that an update is available and will guide you through the installation.
REF: From cnet.com