etymology

Thefreedictionary has an entry:

Pure fabrication or fiction: "He invented, almost out of whole cloth, what it means to be American" (Ned Rorem). "His account of being drugged, kidnapped and tortured was made up of whole cloth" (George Carver). [From the fabrication of garments out of newly manufactured, full-sized pieces of cloth.]

Another meaning is captured by Answers.com:

This expression is a hold over from the days when material was hand made and very expensive. If a garment was made new from material that had been custom made, it was said to be made of "whole cloth", not a patched garment... So the expression "created out of whole cloth" generally is admiration for an excellently told tall tale that is usually a new story. Novels sometimes get their start this way.