Sheep

Sheep are passive mobs 1.25 blocks tall, 0.625 blocks wide and 1.4375 blocks long that supply wool when sheared (hit) and can be dyed 16 colors before shearing to produce colored wool. Sheep naturally spawn in the following colors: white, black, gray, light gray, brown, and pink.

Uses
Sheep are the most easily obtainable source of Wool, which can be obtained by shearing (hitting) them once. Jeb confirmed on Twitter that he is working on shears, which in the future will be the only reasonable way to acquire wool from sheep. Wool can be crafted using 4 pieces of String, but it is less harmful for the player to hit sheep rather than hunt down Spiders constantly.

A block of white wool can be crafted with a unit of dye to produce colored wool. However, a much more efficient method is to apply the unit of dye (right-clicking on a white sheep while holding it) directly to sheep before shearing, as the painted sheep can drop 1 - 3 blocks of colored wool when sheared. Note that non-white sheep cannot be dyed without first being bleached with Bone Meal.

Behavior
Like other passive land mobs, sheep wander around aimlessly, often spawning in flocks of 2 - 8. When they encounter an obstacle, they will often try to jump over it, which makes them look a little odd when they try to jump over taller objects. Sheep can swim and make no attempt to stay out of water; a common sight is several sheep bouncing up and down in the water. Colored sheep behave no differently from their white counterparts.

Dyes can also be applied directly to sheep and shearing colored sheep produces dyed wool blocks of the corresponding color. This is a much more efficient method since sheep drop up to three wool blocks when sheared (as opposed to crafting a unit of dye and a single block of white wool).

Sheep do not drop wool if they are damaged by cacti, lava, fire, an arrow shot from a dispenser, drowning, falling or hit by lightning. Sheep are sheared only when hit, with the exception of with thrown snowballs, thrown eggs, a fishing rod's hook, a skeleton's arrow, or a creeper explosion. However, sheep will also drop their wool when attacked by wild or tame wolves.

History
Sheep were first introduced in Survival Test mode. Before leather was added to the game, wool was used to craft leather armor. Each sheep dropped 1 - 3 white wool when hit (but this did not injure them) and 0 - 2 brown mushroom upon death. In Survival Test sheep would eat grass, turning it into a dirt block. After eating three grass blocks, sheep would regrow their wool. In Indev and Infdev, sheep would only drop 2 blocks of white wool when hit. In an old Indev version, sheep would drop a mix of white, gray or black wool blocks. Sheep then reverted to dropping just 1 - 3 blocks of white wool when hit in Alpha. As of the Beta update, sheep will drop 1 - 3 blocks of the same color of wool as the sheep when it is hit.

In the Beta 1.2 update, sheep could naturally spawn with black, gray, and light gray wool along with the traditional white. Sheep could also be painted with dye and sheared to obtain colored wool blocks. As of Beta 1.4, brown and pink sheep were added to the naturally appearing colors of sheep. Beta 1.6 changed the recipe for wool from requiring 9 pieces of string to 4.

Trivia

 * Sheep are the second mob to spawn with both a separate body and armor file, the first being the pig; the sheep's "armored" state is wooly, while pigs "armored" state is when they are wearing a saddle.
 * All sheep, after being sheared, will have remnants of white wool color on their head and body.
 * Sheared sheep have a more slender head and exposed ears.
 * Sheep can climb ladders.
 * As of Beta 1.6.6 a glitch when leaving the nether while switching tools can cause sheep to rapidly spawn at one time seen here  http://www.youtube.com/watch?v=mmTjQ8SK3vE