to create a character , you would need a 3d modeling application . i use 3ds max , but maya , or even milkshape ( a free 3d app ) can do the trick . then of course you will need to apply a texture skin to it , and then rig it to a biped , which i believe is supplied with the sdk .
so while it seems confusing , its really not too bad if you have enough time to learn how .