On the email server behavior attachment screen. Choose the third radio button to attach the image from the submitted file.
If you want to display an attached image, that can be tricky. I usually suggest using an http:// path to the image if you want it displayed. You can upload the image to your website and then use a full url to display it.
It is possible to embed an image in an email, but it isn't directly supported in the current build and would require some hand coding. That is something I could help with in a premium support ticket.