How to assign a picture to a Contact on your iPod Touch.

1. Tap Contacts.

2. Select the contact entry.

3. Tap Edit.

4. Tap Take Photo if you want to take a new picture. You can also tap Choose Existing Photo and select a photo.

5. Move and scale the photo the way you want it. Drag the photo up, down, or sideways. Pinch or double-tap to zoom in or out.

6. Tap Set Photo and you’re finished assigning a photo to a contact.

Source: iPod Touch Features Guide