You can indicate whether you accept the operation from the DragOver event handler. E.g. this will show the + cursor if you accept the files or the stop cursor otherwise:

private void OnDragOver(object sender, DragEventArgs e)
{
	e.Handled = true;
	e.Effects = DragDropEffects.None;

	var formats = e.Data.GetFormats();
	if (Array.IndexOf(formats, "FileName") != -1)
	{
		var fileNames = (string[])e.Data.GetData("FileName");
		foreach (string file in fileNames)
		{
			if (file.ToLower().EndsWith(".ico"))
			{
				e.Effects = DragDropEffects.Copy;
				break;
			}
		}
	}
} 

I don't think you can set a custom cursor shape from the drag target application, since it is controlled by the drag source. If the source is your own application, check the GiveFeedback event topic on MSDN.

I hope that helps,
Stoyan