Contacts are included with your iPhone's backup along with other data on your iPhone, which is created and maintained/updated by iTunes as the first step during the sync process.
http://support.apple.com/kb/HT1766
But it isn't a good idea to depend on your iPhone's backup alone for this data. Contacts are designed to be synced with a supported application on your computer.
With XP and Vista, this can be with Outlook 2003 or 2007 including calendar events, or with the address book used by Outlook Express (XP) or used by Windows Mail (Vista) called Windows Contacts for contacts only.
If you don't have Outlook 2003 or 2007 available on your computer and you don't currently use Windows Contacts for storing contact info - the address book is empty, before syncing contacts with Windows Contacts, enter one unique contact in Windows Contacts - make the contact up if needed, which can be deleted later. This will provide a merge prompt when syncing contacts with Windows Contacts, which you want to select.
This is selected under the Info tab for your iPhone sync preferences with iTunes.
Before restoring your iPhone with iTunes, you should also import any photos in your iPhone's camera roll even though these photos are also included with your iPhone's backup. If there is something wrong with your iPhone's backup and you don't import these photos before restoring your iPhone with iTunes, you may lose these photos.
After importing photos from your iPhone's camera roll followed by syncing contact info with a supported application on your computer, which will also update your iPhone's backup, restore your iPhone with iTunes. Doing so will completely erase your iPhone first followed by the firmware being reinstalled. After the firmware is reinstalled, you will be prompted to restore your iPhone from your iPhone's backup, which is the default selection. This must be followed by a sync to re-transfer your selected iTunes content including 3rd party apps, and any photos on your computer selected to be transferred to your iPhone.
