Formaldehyde has been used for years on a variety of clothing as a finishing agent. It contributes to the stain-free, wrinkle-free and static-free properties of a garment. The low levels of the chemical used in clothing have historically been considered safe.
However, last year Victoria's Secret got hit with a lawsuit after one woman started developing welts and rashes after wearing one of their bras. The lawsuit snowballed and there is now a class action suit against Victoria's Secret. I'm not sure that this is really a "fair" lawsuit, since you'd very likely find the same chemicals in bras purchased from the mall or any *mart store. Additionally, some people are very sensitive to certain chemicals, while others may wear the same garment for years without issue.
All that being said, even if formaldehyde is harmless at low levels and can be removed with a few good washings, do you really want it in your underwear? You may not be chemically sensitive, but... yuck! Let's not get all gloomy now, though. FaeriesDance.com quite happily offers more than 3 dozen panty options and 2 dozen bras all sans formaldehyde. Now that's something to dance about.