Place the marshmallows, water and vanilla essence (if using) in a large microwave-safe bowl, and microwave on High for 1 minute to start melting the marshmallows. Stir until the mixture is smooth. Gradually add the icing sugar, one cup at a time, until you have a sticky dough. Reserve 1 cup of powdered sugar for kneading. The dough will be very stiff.
Rub your hands thoroughly with butter, and begin kneading the sticky dough. As you knead, the dough will become workable and pliable. Turn the dough out onto a working surface dusted with confectioners' sugar and continue kneading until the fondant is smooth and no longer sticky to the touch, 5 to 10 minutes.
Form the fondant into a ball, wrap it tightly in plastic wrap, and allow to rest it for an hour or so. To use, roll it out onto a flat surface dusted with confectioners' sugar. Cut or shape as per your requirements.
Colouring the fondant
I used Wilton food colours. I added the colours in the end. Initially the colours will create a marbled effect. Roll out the coloured fondant several times to ensure uniform distribution of the colour.
Once the fondant is shaped, leave it out for sometime to dry it. Once it's dried completely, you can store the shapes in an airtight container.
Make sure you the toppers are dried completely before placing it on the cake or cupcake.