UPDATED

Ok, so google has stolen the thunder on my trick here as John pointed out and actually added image embedding as a function last night at around 10pm.

You can read more about it here.

Original Post

Gmail lacks this basic functionality – but with this simple little workaround you will be embedding images into gmail in no time.

1. Click on the link in the top bar that says “Documents“ (you may have to log into  Google Docs)
2. Make a new document.
3. Click on Insert and then Image – a window should appear that allows you to add an image from your computer or insert the url of your image – selected whichever method you need.
4. Your photo is now in your Document.  Highlight it – copy it – and return to your gmail window.
5. Paste it and enjoy.