Gmail has a new Labs feature that allows you to “insert images”, in rich formatting mode. Just turn on "Inserting images" from the Labs tab under Settings, and you'll see a new toolbar icon. Clicking the icon, will let you insert images in two ways: by uploading image files from your computer or providing image URLs, though neither approach will guarantee that your image will be shown in email clients on the receiving end... for instance, Gmail protects recipients from URL-referencing images, and Hotmail protects even from embedded images. So if you're sending mail to other Gmail users, they'll still have to click "Display images below" or "Always display images from ..." to see images you embed.

Tip: if the uploaded image is too large, click on it and choose from the available sizes (small, medium, large) or resize the image by dragging one of the corners.