As in Morrowind, character creation is integrated into the game. You start the game in a prison cell. You are never told why you are there ("It doesn't matter," as the Emperor will tell you), so the reasons for your imprisonment will forever remain a mystery and you are free to concoct whatever circumstances you want. If you want to play a bad-guy type of character, you can assume that you got caught in some sort of shenanigan and are getting your just reward. If you want to play a good-guy sort of character, you can assume that you are the victim of mistaken identity and that everything will sort itself out eventually. If you envision yourself as being somewhere in the middle, you can assume that you got nailed for something rather minor or humorous, like having a little too much of that Cyrodiilic Brandy and taking a leak on the leg of the local beat-cop (an interesting trick if you happen to be female, but I digress). As part of the introduction to the game, you are visited by Emperor Uriel Septim VII and three guards while on their way out of the palace (why the Emperor's secret escape route runs through your prison cell is another one of those eternal mysteries, like why 24-hour stores have locks on the door). Long-time players of the Elder Scrolls series may recognize the cell you start in as the same cell in which you began Arena with better graphics (talk about coming full circle).
In any event, speaking with the emperor is where you begin creating your character. In Morrowind you created your character in three or four separate sequences (providing your name to the prisoner on the ship, providing your race, sex and appearance to the guard on the dock, and providing your class and birthsign to the clerk inside the Census and Excise building). However, in Oblivion, these sequences are a bit farther apart in time than in Morrowind. When you start the game, you are asked to provide a name, sex and race and you can have a lot of fun designing your character's face (sorry, no scars or eyepatches). You will play through the Tutorial part of the game without a class, so all of your skills will be at 5, plus any racial bonuses. This is not that big of a deal as Rats and Goblins aren't too much to handle, even for a no-class 1st level character. Be warned, the Tutorial dungeon will take you a couple of hours to get through (more if you die and have to reload a saved game). But it will show you how to do everything that you're going to need to be able to do to play the game. All in all, I was extremely impressed with the attention to detail that went into it. It's a fun little episode. And, as an added bonus, you get to keep whatever skill increases you earn along the way. You're not going to see any major gains in most skills (Rats and Goblins don't stand up for very long), but you can start with major bonuses in Stealth, Athletics, Acrobatics and Restoration by taking your time.
You'll fill in the rest of your character (birthsign and class) later, after your final encounter with the Emperor. Based upon your style of play in the introduction, the game will suggest a standard class, but you can accept or reject that suggestion. Before you finally exit the introductory/tutorial area, you'll be offered the chance to change and tweak all of your character choices, so don't feel that you're locked in with anything that you choose at the beginning. In fact, it might be a good idea to save the game at the point where you can make all of those changes so that you can come back and make those changes without having to go through all of the introductory stuff again (if you choose to take this route, make sure that you don't delete that saved game later).
There are a few basic approaches to creating a character. First, there is the role-player approach in which you start with a character concept and design your character, carefully selecting race, skills, specialization and birthsign to match your design concept. Second, there is the impatient approach. This player wants to get into the game as quickly as possible and generally selects standard classes with the default settings or a few tweaks. Then there is the power-gamer who wants to create a 95th-level demigod that flattens cities with a wave of his hand and doesn't much care about anything other than how many critters he can flatten in the shortest period of time. Happily, Oblivion will accomodate all three styles and everything in between.