Lay a drop cloth below the area of paneling where you'll be working, and tape it to the top of the baseboard. Tape drop cloths in place on areas that butt up against the drywall to prevent spreading the drywall compound beyond the paneled area.
Put lightweight spackle on a trowel, and begin to work it into the grooves on the paneling (lightweight spackle contains less moisture than regular spackle, and should barely contract when dry). Push the spackle into all the grooves thoroughly so no pockets of air remain underneath, pushing down with your fingers if necessary; this will reduce any possibility of shrinkage. Repeat the process for all the grooves in the paneling; don't worry if some of the spackle ends up on the paneling itself as you'll be sanding this down.
Spackle all the nail holes, and then leave all the spackling to completely dry -- overnight if possible. Test to ensure it's hard before floating drywall compound on top.
Put on the safety goggles and dust mask. Place fine-grit sandpaper in an orbital sander, and start to sand the paneling. Roughen all the wood, and be sure to remove the gloss from the wood. Sand down all the spackle so it's smooth and level with the wood. Clean with a cloth, and test the wood for smoothness with your fingertips.
Mix the drywall compound using a stick. Put the compound on the drywall knife, and start to float over the paneling. Work in smooth strokes. Apply a thin coat, enough to cover the paneling completely, and then leave it to dry overnight.
Sand down the drywall with fine-grit sandpaper until it's smooth, and brush away the dust with a clean cloth. Start to float a new coat of drywall compound on the paneling, using a wider blade drywall knife, and make sure it is thicker than the first coat. Smooth it out as much as possible with the drywall knife, and then leave it to dry overnight. Sand down with very fine-grit sandpaper until completely smooth. Wipe away all the dust with a cloth.