Prepare the paneling by washing it with a solution of TSP (trisodium phosphate) and water. Wash the paneling with a sponge or cloth, then rinse it with water. Let the wall dry, then apply masking tape to molding, trim work, and other areas you don't wish to refinish.
Use a brush, roller, or pad to apply a coat of latex (water-based) stain-blocking primer if you simply wish to paint the paneling. Details such as panel grooves and wood grain will still be visible. Let the primer dry and apply another coat if the original color of the paneling shows through. Add two coats of acrylic latex interior paint for the final finish.
Use a putty knife to fill the panel grooves with joint compound (Sheetrock mud) if you want a smooth or textured finish to paint or wallpaper. Allow the compound to dry as directed by the manufacturer and apply additional coats until the grooves are flush with the surface of the paneling when dry.
Use a drywall trowel to apply joint compound to the rest of the wall. Spread it evenly for a smooth surface or create a textured finish with a skip trowel or sponge. Let the joint compound dry and sand down high spots with medium-grit sandpaper.
Wipe the surface clean of dust and apply a coat of latex primer and two coats of acrylic latex for a painted finish. If you prefer wallpaper, glue it directly to the dried joint compound.