If you are using a Mac and add a picture to an Address Book contact, and then sync to your iPhone, the next time that you receive a phone call, the picture will appear small by the number of the person who is calling you.
If you are a PC user, I'm sorry, but I really can't help you too much there. However, if the address book on your PC allows for pictures, which I'm sure that it does, then give that a try and then sync. I'm sure that it would do the same as if you were using a Mac.
If you take a picture of a friend using the iPhone, and then apply that picture to their contact information, this is when the picture ends up becoming a large wallpaper sized picture on your phone when you get a call.
It'd be nice if we could choose to make the picture either a thumbnail or wall paper within the iPhone itself.