How do I get good quality photos onto an iPod Touch?
You may want to try a re-sync if you recently updated to iOS 4.x

This resolved the issue for a user here:
http://forums.macrumors.com/showpost.php?p=10844169&amp;postcount=2


  this happened to me when I first upgraded my 3GS from 3.1.3 to 4.0, the moment the upgrade was complete, I unplugged my phone to browse the new features and I quickly noticed all my photos were low res, so I plugged my phone back to computer and hit sync, this time iTunes said "Optimizing Photos". Once that was complete, photos were back to normal.