Here are the best answers I've got for my present interpretation of what you're trying to ask. It's possible I'm misunderstanding your questions, though, so if any of this seems to miss the mark, please rephrase the questions, if you could.
From: Kathleen Foxdale
1. I'd like to have my text or pictures on my clothing, lets say shirts, not be blurry as it would be if i made it in photoshop.
You appear to be operating from a flawed premise. Photoshop isn't what's making your shirts blurry. Whatever effect you're looking to create, be it crisp text, or anything else you could think of, Photoshop itself is more than up to the task. It's on you as the artist at the controls to make your art the way you want it to be.
If a full-featured program like Photoshop ever seems like it's not doing the job for you, chances are good that there are just some aspects of it you haven't yet learned how to control. It's usually a good idea to ask how to solve any given problem directly in the software you're already using, before you go looking for alternate solutions in other programs, if that makes sense.
Rolig offered a few general tips. I'll add a few more:
First, for characters to be legible, they each have to be above a certain size, so that there will be enough pixels in them to well define their shape. The minimum will vary in accordance with the font you're using, and the coloring/contrast of the image.
Second, Photoshop offers several different anti-aliasing modes for text. Which one is best will vary, again depending on the font, the coloring, and what's going on in the image. Every time you lay down any text, it's a good idea to cycle through the various AA modes, to see which one appears to work best for the specific circumstance.
Third, keep the contrast high. Neighboring colors with similar luminance values will make for lousy legibility. So don't put bright yellow lettering on a bright white shirt, for example. Instead, pick something similar, but with better contrast. To stick with the same example, maze against a pale gray would read better than pure yellow against pure white. If you absolutely need to use two colors that are similar in brightness, then perhaps put an off-color stroke around the letters, or a drop shadow, anything to break it up, and add a healthy degree of contrast.
From: Kathleen Foxdale
So I decided to try using illustrator and saving with it.
So you know, as soon as you export to a raster format (which is what textures are), the text is going to be treated exactly as Photoshop treats text. You can get equally crisp or equally blurry results from either program, depending on settings.
From: Kathleen Foxdale
However, when I save with illustrator, the image is automatically cropped on the sides/bottom/top of the template which I did not work with. So the actual shirt is right on the edge of the image, and that comes out wrong on the avi. Is there an option that I need to check so that doesnt do this? I tried saving as png and .ai file, and they both were cropped, even when I imported back to photoshop.
By default, Illustrator will crop the image to the size of the actual artwork when outputting rasters, without regard for the size of the artboard. If you want your raster image to be the size of the artboard, there are several ways to go about it. Here's one. Instead of outputting via Save, or Save As, instead use Save For Web & Devices. In the right hand column of the Save For Web & Devices dialog, click on the Image Size tab. Then check the box labeled Clip To Artboard. Hit Apply, and you're all set.
From: Kathleen Foxdale
2. If i import the illustrator img back to photoshop, will the img become flat/blurry again? How can I make the image clear and sharp?
That's pretty tough to answer without knowing exactly what you've been doing, and exactly what you're seeing. It shouldn't blur as soon as it's opened in Photoshop, if that's what you mean.
From: Kathleen Foxdale
And when I mean blurry, I mean when you zoom into the clothes in the game, it because fuzzy a little and may be hard to read.
Well, everything will blur to some degree when you magnify it. Think about what's actually happening. The area of texture canvas that constitutes the front of a shirt is only about 200x300 pixels. And the back is even smaller, roughly 175x275. If you've got an average size monitor, and you zoom in so the shirt fills the height of the screen, you'll be viewing at anywhere from 9-25 times its actual size. So OF COURSE it's going to blur a bit.
And the higher the contrast in the image, the more apparent the blurring will be. Text tends to be high contrast, as we discussed above.
This is not just an SL thing. Blow up rasterized text in any other environment, and it will blue there too. To give you an idea, here's the SL logo, screenshotted directly from the top of this website, and then magnified by 500% on each axis.

That text looks plenty blurry when zoomed in on like this, even though it's nice and crisp at its original size.
The reason you don't see text blur when you enlarge it while it's in active use is because it hasn't been rasterized. Text is all vectors before you flatten it into an image. Vectors have infinite resolution. Raters, on the other hand are made up of actual pixels, so their resolution is fixed. The only way to enlarge a raster image is to add extra pixels to it. And as soon as you do that, the image blurs. There's no way around that.