I determined I upgraded to the current version (14.0.8117.0416) on June 20th. Could that be the problem? Other than Photo email failing to associate a web link with the thumbnail image, everything else seems the same.
I was using the beta version of WLM, but reverted to the earlier version that you're using, because Beta's got too many features missing that I regularly use, like back ground format, etc. My sending format is SMTP.
I sent a test message to myself using the drop down menu of "New" and chose "Photo Email". When it opened, it auto showed an option to add the photos, which I did, and used the "Layout" button to show them as "Thumbnails". They were shown in the main body of the text. I was not signed in to Windows Live.
When I received them, they appeared as full size phtotos in the main body of the email text and could only be saved by right clicking each individual photo. The option to save as high res was grayed out. And the actual saved image was a thumbnail, not a full size pic.
I then repeated the experiment but this time I signed in to Windows Live using the "Sign in" option in the main GUI of WLM - top right hand side of window.
This time it worked perfectly. The incoming test email showed the pics as thumbnails, and they could be viewed in the interface of the main text of the message as a slide show. They could also be saved as a group with one click, or saved individually in high res.
Prior to this I had never used Photo Email so can't compare it to earlier results.