This worked for me for about a minute and then they went blurry. I tried calling the contact over and over to see if it would change and it was fine until I switched to my Favorites widget and actually watched as it turned from clear to a pixelated mess. I thought (hoped) it might have something to do with the Favorites but I still had the same issue after removing the label and applying the picture again.
However, the picture I was trying to use was from the web, and the one I tested from a camera photo (on another contact) seems to still be crisp. So at least there's that. Still sucks you can't use downloaded photos.
EDIT: I tried applying the same web photo that screwed up previously onto a contact that only had one number and nothing else linked to it, and this time it hasn't blurred yet. So could it have something to do with the links that is distorting it somehow?