From page 30 of the iOS 4.1 users manual
Adding Wallpaper
You can set an image or photo as wallpaper for the Lock screen. On iPod touch 3rd
generation or later, you can also set wallpaper for your Home screen. You can choose an
image that came with iPod touch, or a photo synced to iPod touch from your computer.
Set wallpaper (iPod touch 3rd generation or later):
1 In Settings, choose Wallpaper, tap the image of the Lock and Home screens, then tap
Wallpaper or an album.
2 Tap to choose an image or photo. If you chose a photo, drag to position it and pinch to
zoom in or out, until it looks the way you want.
3 Tap Set, then choose whether you want to use the photo as wallpaper for your Lock
Screen, Home screen, or both.