Here's what's happening: in iOS 7 wallpapers must be at least the full dimension of the screen size. So if your photo is smaller that the screen size (which it always will be on an iPhone 5) then iOS will enlarge it so that it fills the lock screen view.
Here is a simple way around it: while in your Camera Roll, view the picture so it has a black background. Take a screenshot (press home and lock buttons at same time). You can then use that screenshot as a wallpaper (instead of the original photo) without having the same issue with enlargement because a screenshot is already the right size for iOS.
Hope that helps!