Gmail Labs now offers embedding images into emails.You can upload the files which appear as small thumbnails. Once you select the required image you have the option to resize them within your email message to thumbnail, medium, large and original dimensions.This feature that can be found in Gmail Labs (under “Settings” -> “Labs”).
In order to insert an image you'll have to have "rich formatting" turned on. Once it is, you should notice an image icon squeezed between the emoticon and link icons. Click it and you can upload an image to post in the body of your message. That's it.
Gmail doesn't show URL-based images in messages by default to protect you from spammers, 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.