Some of you may have noticed that lately, you can no longer add photos directly into the body of a Windows Live Hotmail message the way you used to do. The Windows Live team is constantly reviewing Hotmail to ensure quality service to our customers. During a recent review, we identified an incompatibility with Internet Explorer that raised a potential security concern with photo uploads, and we made the decision to temporarily remove the feature.
The Hotmail team takes security very seriously and we expect to bring back the photo upload feature by the end of September. In the meantime, you can still add pictures as attachments to your Hotmail messages, by clicking Attach, and then File, and then selecting the picture you want to include.
We apologize for any inconvenience that this may cause you until this fix is complete.
The Windows Live team
Windows Live team blog archive 
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