You can add a photo to a contact by opening Contacts, tap on the desired contact, press the "Edit" button in the upper right corner, and tap on the square labeled "add photo" to the left of the contact's name. Next, tap on the "Choose Existing Photo" button and you are taken to the Photos app where you can select the desired photo.
If you have an iPhone, you can take a photo of the person and select that for the contact photo. You can also import photos of the individual from your Mac or PC using the iTunes sync feature. Finally, you can attach photos to e-mails and send them to your iPhone or iPod touch.
Once you've selected the photo you can size the photo to zoom in on the face. Tap on the photo, which at this point should be labeled "edit." Then, tap on the "Edit Photo" button in the pop-up menu. This takes you to the "Move and Scale" screen where you can adjust the picture.
You can use pinching gestures or double tap on the screen to change the size of the image. You can also use your finger to drag the image to center it. When you're satisfied with what you see, tap on the "Choose" button and the photo is saved to the contact. Look over the contact info one more time to make sure everything is accurate and press the "Done" button in the upper right.