since you want to use the clothes in the original size/shape, i would applique them by hand or machine to your square block. then i would cut out the back of the quilt square and then the baby clothes back. that way, you won't have to worry about the cut edges of the clothes. i'd also start with a larger than 12" square and trim it square after the applique as the applique sometimes draws up the flat fabric. be sure to show us your progress.