Using iPhone as iPod touch

I am trying to use an old iPhone 3GS as an iPod touch. I left in the old sim card and connected it to iTunes but it will not activate.

This should work, but might not be ideal - get a pay-as-you-go (i.e., non-contract) SIM with a small amount of credit on it (I suppose not everyone has them lying around) and activate it with that (it needs to be on the same network that the phone is locked to) and then disable all the 'phone' functions. It should then function just fine.

Per Apple's support documentation you'll need to activate the device using a SIM from another activated iPhone to activate the device. If you don't have access to another SIM card you could consider taking the device to an Apple store, or a mobile vendor that carries iPhones. If you don't have access to either of those, as a last resort you could download Redsn0w and activate the device without a SIM. The last method is not supported by Apple, but will accomplish your task.