Hey guys, I made this post over at the Android Help forum on Google.com. If any of you are having this problem, please reply to my post on there so it gets brought to Google's attention. I hate not being able to use the Droid's high-res display to its full ability because of issues with Android. Post located here: Blurry, low resolution Album Art/Contact Photos because thumbnails are being used instead of the full-res source image. - Android Help
I spent a night troubleshooting this issue and I'm now sure it is a problem with the Android OS. When you apply album art to an mp3 or a contact photo to one of your contacts, Android makes a low-resolution thumbnail of that image to display where a smaller-sized picture is appropriate (i.e. the small boxes in your contact list, and the small album art when you scroll through your mp3s in the music player).
It appears that Android is then taking this lower-resolution thumbnail and using it where the larger, higher-resolution source image would be more appropriate (i.e. the contact photo when placing/receiving a call, and the larger album art picture when listening to a specific mp3). This causes the larger displaying of album art or contact photos to appear blurry and/or pixelated.
This seems like it would be a relatively easy fix and it would greatly improve the aesthetics of the Android OS. As of right now, it is embarrassing to have contact photos or album art applied to my phone because their quality appears awful. With such high-resolution screens, we should be able to showcase the aesthetics of Android rather than try to hide them.