Point your iPhone where you would like to start, then tap the camera icon (highlighted in the photo with a blue circle.) Pan (swing the camera around horizontally, holding your iPhone steady) slowly in the direction of the white arrow.
For best results (this is the bit that reads like the back of a shampoo bottle) as you pan, as much as you can keep the point of the white arrow directly on the white horizontal line.
Tap Done, to finish.
To change the panning direction tap anywhere (illustrated inside the green box in this picture.)
Notes: Panorama is available on iOS6 for iPhone4S and later. Third party apps are available which can produce cool panorama shots too. Search the App Store for "Panorama" I can recommend Panorama 360.