To change body composition and to reduce your overall size, strength training is the key. Muscle is considerably denser than fat - take a look at www.dailyspark.com/blog.asp?post=quiz_how_
for a great photo of this.
Aim at a moderate calorie deficit - say around 0.5 lbs per week. And make sure your strength training is genuinely challenging - once you can do 12+ reps, it is time to move up to a heavier weight/more challenging exercise. A very simple all-body routine would be:
* pushups (modified/wall/incline pushups if necessary)
* pullups/lat pull downs/bent over dumbbell rows