I am trying to write a proxy which reads an image from one server and returns it to the HttpContext supplied, but I am just getting character stream back.
You're going to need to set the Content Type on your response. Here's a snippet of code that'll do it:
// specify that the response is a JPEG
// Also could use "image/GIF" or "image/PNG" depending on what you're
// getting from the server
Response.ContentType = "image/JPEG";