Is this just a problem with synced contact pictures? Because I've just tried a factory reset, then added contacts to the phone before I've even set up any accounts to sync (even going so far as to turn off Wi-Fi) and I still get awfully pixellated contact images on the contact card so it seems as if there's local compression going on.
Also if I edit a contact picture and select 'My profile' as the image, then save and repeat this process the image gets more and more pixellated until it's just a mushy mess of colour.
Surely there should be at least the option of uncompressed contact images?