The two subquestions I have created have been solved (yay for splitting this one up!), so this one is solved. I\'ll award the check mark to samjudson, sinc
There is a new Data URI specification http://en.wikipedia.org/wiki/Data_URI_scheme which may be of some help provided you are only intending to support modern browsers, and your images are small (for example IE8 only support <32k images).
Other than that the only other thing you can do is use some external scripts to export the image data to file and use them. This would depend greatly on what XSLT processor you are using.
It exists a pure XSLT answer to this issue ; look at this page