There are two ways to include an image in a Windows Phone 7 project (that I know of). As content or a resource. Resources are included in your assembly (DLL) while content is included in your deployment package (XAP) alongside the DLL.
Resource
If you copy and paste an image into your project, the default build action is “Resource”. You can see this by selecting the image and viewing the properties.

When you reference an image that is a resource, the name of the assembly is appended to the reference. Funky.
<Image Source="/WindowsPhoneApplication1;component/Untitled.png" />
If I look at the XAP file for this project (by changing the file extension from XAP to ZIP), then I can see that the image is nowhere to be found. That’s because it’s in the DLL (note the large file size for WindowsPhoneApplication1.dll).

Content
The other choice is to include images as content. This is done by switching the build action in the properties window.

References to content images are much less funky compared to the resource images.
<Image Source="Untitled.png" />
But the most obvious difference is in the packaging. Now, my image is sitting inside the XAP instead of embedded in the DLL. Note the difference in file size between the DLL now and when the image was embedded as a resource. It’s one-fourth the size.

Which one do I use?
Each build action has its place. Setting your build action to Content means that your application will load faster since the initial DLL will be smaller. Jeff Wilcox points this out in his interview with Scott Hanselman.
Update: As Matthieupointed out in the comments, Content is the way to go for your application bar icons. Otherwise, they will not show up and you’ll get the ugly default.
On the other hand, settings your build action to Resource will let you redeploy your DLL and the image with it. This would be good for a class library
It’s interesting that the default is Resource – I usually change my build action to content for the faster load time and the easier-to-read XAML.
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