I expect it's reproducable, but to do that I'd need to build a server running 5.0.2 NE and sync an iphone 1.1.4 to it via itunes/outlook and then upgrade to 5.0.8 and 2.0 and see what happens.
As I dont deal with a large amount of contacts, and it's no one else in the company is likely to have images already assigned in their contacts I set about a workaround.
I opened each contact in firefox, then used tools-page info to save out the actual 320x320 images stored for the contact and then imported it back in on the web client. Instantly, this caused the photo to be sent back to the phone. Once this was done for all the contacts, I took another iPhone and set that up for activesync to the same account - all images were sent to the phone.
I'm quite sure there's a real issue here, but it's not necessaily an important issue

If anyone else comes accross the same issue but has hundreds of contacts to deal with, then this is worth further work, but for now I'd give up on it - it only seems to exist under a legacy set of conditions.
jjzhuang - thanks a lot for your help.