I am starting to depend heavily on the IPython notebook app to develop and document algorithms. It is awesome; but there is something that seems like it should be possible,
Files inside the notebook dir are available under a "files/" url. So if it's in the base path, it would be <img src="files/image.png">
, and subdirs etc. are also available: <img src="files/subdir/image.png">
, etc.
Update: starting with IPython 2.0, the files/
prefix is no longer needed (cf. release notes). So now the solution <img src="image.png">
simply works as expected.
Change the default block from "Code" to "Markdown" before running this code:

If image file is in another folder, you can do the following:

You can find your current working directory by 'pwd' command in jupyter notebook without quotes.
First make sure you are in markdown edit model in the ipython notebook cell
This is an alternative way to the method proposed by others <img src="myimage.png">
:

It also seems to work if the title is missing:

Note no quotations should be in the path. Not sure if this works for paths with white spaces though!
I am using ipython 2.0, so just two line.
from IPython.display import Image
Image(filename='output1.png')
<img src="files/image.png" width="800" height="400">
from IPython.display import Image
Image(filename='output1.png',width=800, height=400)