The Mason-Dixon knitting book has some patterns for hand towels and washcloths. I actually made the moss stitch hand towels. I used Plymouth (not sure of the exact name...am at work). It was part linen and part something else.
While this made a pretty towel, it's not real absorbent.
I think the book recommends Peaches and Cream. I was a very new knitter when I started these towels. I didn't know that Walmart carried this yarn. I bought the more expensive Plymouth yarn at an LYS far from me (don't have specialty yarn stores here).
the Peaches and Cream website.