Fluorescent nanodiamonds (FNDs) emit in the near-IR and do not photobleach or photoblink. These properties make FNDs better suited for numerous imaging applications compared with commonly used fluorescence agents such as organic dyes and quantum dots. However, nanodiamonds do not form stable suspensions in aqueous buffer, are prone to aggregation, and are difficult to functionalize. Here we present a method for encapsulating nanodiamonds with silica using an innovative liposome-based encapsulation process that renders the particle surface biocompatible, stable, and readily functionalized through routine linking chemistries. Furthermore, the method selects for a desired particle size and produces a monodisperse agent. We attached biotin to the silica-coated FNDs and tracked the three-dimensional motion of a biotinylated FND tethered by a single DNA molecule with high spatial and temporal resolution.