Is your phone jailbroken? If so, you'll get that error & you won't be able to update, you'll only be able to restore as a new device, and yes, you will lose all saved data on your phone.
Ok. I asked, because I've previously seen that error on jailbroken phones where iTunes will refuse to restore from backup. Do this:
The iphone backup is not stored in your iTunes library, its stored here:
* Mac: ~/Library/Application Support/MobileSync/Backup/
* Windows XP: \Documents and Settings\(username)\Application Data\Apple Computer\MobileSync\Backup\
* Windows Vista and Windows 7: \Users\(username)\AppData\Roaming\Apple Computer\MobileSync\Backup\
Copy the contents of that folder to your desktop, you will have to turn show all hidden files & folders on to see your backup folder. Once you've done that restore your phone as a new device & not from backup in itunes. Follow this by syncing your itunes content back to your phone. Apps & music are not part of your iphone backup & should already be in your itunes library. Regarding the photos in question, are these photos in your camera roll? If so, import them to your computer BEFORE you proceed. Are all of the apps in question in your itunes library? If not, transfer them BEFORE you proceed: with your phone connected, itunes running, right click the phone in the device pane & select transfer purchases. You can also re-download purchased apps for free.
