I am one of those developers, and I can tell you, if the received photo is much smaller than the iPhone's screen res, the photo is pixellated and blurry.
Here is a for example. I took a quick snap of my watch and cropped it down to smaller than the iPhone screen resolution. much smaller actually, say 1/4 to 1/3 the size. Still within the realm of the size you might get from a "dumb" phone.
Actual size from email (emailed using the photogene app)
Here is a screen shot of what it looks like if emailed from the photos app
and here is the thumbnail view from the messages app
And here is fullscreen from the messages app
Personally, I would rather have it at it's native size with a plain black border around it to fill up the rest of the screen. It's useable, but it is a problem with the iPhone and the photos app and the way it integrates with the mail app and messages app.