I have an iPhone 4S and the latest iMac. I manually manage my content on my iPhone - I don't have anything automatically sync on it. But when I drag music over to my iPhone the album art does not travel with it. I have most of my audio in AIFF format in iTunes - other than stuff I buy digitally. I have found that once the audio is over on my phone, I then have to copy the artwork over not once but TWICE before it will update on the phone and show up. It does work though and that is fine.
My problem now is I purchase digital 'compilations' where each track has a different album cover because they come from different albums. I just dragged over 250+ tracks and I'm not going to go in 1 by 1 and copy the album covers over twice for each track.
My phone used to update properly but in the last few months it stopped doing it properly so I'm wondering if there is something that needs to be reset on it to get it to work properly again.
I have all the files on my iPhone coverted to 128K for size issues and all my files in iTunes are at least 320K or higher so they all get down-converted when they are moved onto the iPhone. I assume the artwork is somehow getting 'lost' in this conversion process.
There's a script on the Dougscript web site that embeds album artwork in a file. Try that for a file and see if it works.