The term was developed in the past year (2005) by a bunch of Canadian students on an Ottawa trip.
It is often used to describe "muging" of shoes while the subject is distracted. Originates from the word Mug - which relates to robbing, whether at gunpoint or not. The "M" was replaced with an "F" to stand for foot, or feet.
It is also often used to replace the F word in many cases, and can be used as cover up when around older people.
"Oh my god she got Fugged!"
"Man he was fugged good!"
"Fugging piece of crap!"
"Why the fug did you do that?"