I don't know how fiddler is doing it, but it can be done via a Layered Service Provider on Windows.
From Wikipedia:
"A Layered Service Provider (LSP) is a feature of the Microsoft Windows Winsock 2 Service Provider Interface (SPI). A Layered Service Provider is a DLL that uses Winsock APIs to insert itself into the TCP/IP stack. Once in the stack, a Layered Service Provider can intercept and modify inbound and outbound Internet traffic. It allows processing all the TCP/IP traffic taking place between the Internet and the applications that are accessing the Internet (such as a web browser, the email client, etc). "