The players pick a starting image, then one player makes some sort of alteration to the image in any graphics manipulation package that they like. They then send their altered image, usually via email, though posting the image to a Photoshop tennis forum is another possibility, to the other player, who then edits that image and sends it back to the first player.
[Photoshop tennis entry]
SITO began dabbling in something very similar to Photoshop tennis way back in January 1994. It was (and still is) known as PANIC. At its fundamental level, play transpires exactly as is described in the Wikipedia excerpt above: players start with an original/base image, and take turns manipulating it in subsequent "volleys". Like Photoshop tennis, more than two players can be involved (in the case of PANIC, this was common), however, unlike Photoshop tennis, there is no (formal) competition or judging of final outcomes. Typical, though, players would discuss (via IRC) the progress of each session and their results.
One of the first public announcements for PANIC can be seen in this Feb. 11, 1994 Usenet post.
PANIC continues to this day, albeit in a very casual manner and in the shadow of more popular Synergy projects, such as Gridcosm.